US Small Caps: Opportunities Hiding in Plain Sight?

Viewed through this lens, the issue is a comparison distorted by an extraordinary period of large cap leadership. On its own fundamentals, US small cap is a sound equity asset class. This reframes the core question: Not whether small caps are broken, but what are the compelling opportunities within the asset class for active managers with the tools and the know-how to implement the right approach?

A Structure Well-Suited to Active Management

The vast nature of the US small cap universe—composed of more than 2,500 companies—helps explain why an active, research-driven approach is particularly well-suited to the asset class. Business quality varies widely and many companies are simultaneously navigating periods of transition. At the same time, the size of the investable universe poses a significant hurdle to traditional investment approaches and leaves the asset class under-researched relative to US large caps.

For example, the research coverage gap between small and large cap companies is substantial and a meaningful source of opportunity for active managers. As shown in Exhibit 2, 57% of Russell 2000 companies have five or fewer sell-side analysts, compared with just 1% in the S&P 500 Index. Meanwhile, only 15% of small caps have more than ten analysts, versus 89% of large caps.¹

This imbalance leaves much of the small cap universe with limited in-depth analysis, slower information flow, and greater potential for mispricing. For fundamental investors with the right tools, this disparity highlights why small caps remain attractive: Less coverage can create more room for differentiated research and meaningful security-selection alpha.

Furthermore, a diversity of fundamentals creates uneven earnings streams and uncertain outcomes, which can increase pricing inefficiencies. As of March 2026, roughly 38% of the Russell 2000 Index consisted of nonearning companies—a group that often includes businesses undergoing restructurings, cyclical recoveries, operational turnarounds, product-cycle shifts, or early-stage normalization after challenging macro conditions (Exhibit 3). 

Disciplined security selection, balance sheet evaluation, and understanding a company’s path to profitability become essential. Identifying and recognizing these dynamics can materially influence outcomes. The difference between passive index exposure and selective ownership is especially meaningful in a market with many nonearners and transitioning businesses.

In our view, these features underscore that US small caps remain a resilient asset class, and their inherent dispersion and complexity continue to create a compelling opportunity set for active managers. Active managers can be selective in what they own; passive indices, by design, must hold the entire spectrum of the market—including assets those investors might prefer to avoid.

The Small Cap Side of AI

The artificial intelligence (AI) segment is often framed as a mega cap investment theme, often because the largest perceived platforms and infrastructure providers sit at the top of the value chain. However, the broader AI buildout spans an ecosystem that is not limited by company size and small cap companies play a crucial role in enabling this growth.

AI solutions include a wide and diverse set of components including power and energy infrastructure, data center supply chains, cooling and thermal management, networking and connectivity, optics, vertical software, and domain-specific applications. Across these areas, small cap businesses can have meaningful exposure, often in ways that are less visible and less crowded than at the large cap level.

For investors, we believe a large portion of the opportunity in AI lies in identifying companies where AI-related demand translates into measurable fundamental improvements. So, how can small cap investors tap into this exposure? We believe the opportunities come to those able to identify the less obvious, more nimble AI companies that present a clear path to growth and profitability. These can include specialized power and thermal management providers tied to data center buildouts, niche semiconductor equipment and testing companies, optical and networking component suppliers, and vertical software businesses embedding AI into their products.

Our proprietary, automated approach is designed to evaluate the full small cap universe against these dynamics systematically, surfacing companies where AI-related demand is already showing up in stronger order growth, higher utilization rates, and margin expansion, rather than relying on thematic narratives alone.

Can Private Equity Play a Supportive Role?

Investors often question if private equity is the reason that the public small cap universe has lagged, based on the notion that sponsors buy the most attractive businesses and leave public investors with a weaker remaining universe.

We believe that view overlooks an important dynamic: Private equity can also act as an external price-setter of companies. Sponsors tend to acquire public companies or support strategic lift-outs, at meaningful premiums, when they see scarce assets, durable cash flows, consolidation value, or operational improvement potential.

For fundamental investors, this activity can be constructive. Identifying strategic value before it is broadly recognized can allow acquisitions to serve as a source of realized alpha, not simply a reduction in investable names. In that sense, private equity activity can actually help crystallize value for public-market investors.

A Systematic Approach That Navigates Small Markets: Identify, Quantify, Validate

The argument for active management in US small caps rests on the characteristics described above: a broad opportunity set, wide dispersion in outcomes, uneven quality, and constant change at the company level. In this kind of environment, the challenge is not simply finding good businesses but also seeking to identify improvements early, aiming to avoid structural losers, and doing so systematically across a universe that is broad and dynamic.

At Lazard Baylight, we believe a systematic approach to small cap investing can help identify opportunities that are not always obvious yet may sit at compelling inflection points. To achieve this, we leverage a fully automated, fundamentally oriented stock selection process that evaluates core fundamental concepts such as competitive advantage, industry leadership, and management quality.

This process is centered around 28 proprietary Automated Fundamental Analysts, or AFAs. Each AFA applies objective, rules-based frameworks to assess every company. The AFAs are designed to replicate fundamental analysis in a way that is systematic, consistent, and scalable across the investable universe.

This approach is designed to anchor first on observed fundamentals and valuation rather than on headlines or sentiment. In our opinion, this provides a valuable foundation. Small cap markets can be especially prone to narrative-driven dislocations, particularly when speculative segments lead or when investors extrapolate thematic enthusiasm ahead of operating results. Our approach does not dismiss thematic drivers such as AI, reshoring, or electrification. Rather, it requires that the benefits of those themes appear in a company’s fundamentals before we act on them. This protects against narrative-driven mis-pricings and often points us toward overlooked beneficiaries.

What is the result? The potential to build a diversified and dynamic portfolio of small cap opportunities made up of differentiated return streams.

Conclusion

US small caps can be misread but investors should not ignore the potential upside—diversification, growth potential, and the opportunity to tap into under-researched companies. In our view, a systematic fundamental process is especially effective because it allows investors to evaluate breadth at scale, respond to change with consistency, and pursue alpha based on improving fundamentals rather than shifting narratives.

The current US small cap market should not be defined by a backward-looking narrative of structural impairment. It should be understood as a broad and differentiated opportunity set in which careful fundamental work, disciplined risk management, and early identification of improvement can be rewarded.