The AI-driven rally in mega-cap stocks has widened the performance gap between large and small caps, leaving smaller companies trailing across global equity markets. While small caps have historically delivered stronger long-term returns than their larger peers, that outperformance has been notably absent in recent years. Norwegian independent wealth manager Norcap AS maintains exposure to global, Norwegian and Nordic small caps, but Jarle Sjo, Head of Research, argues that the case for small caps is far from a one-way bet. The forces behind large-cap outperformance, particularly technology and AI, could remain in place for some time.
From no-brainer to more nuanced case
Sjo recalls that the case for small caps looked considerably clearer before the current technology boom. “Before 2020, 2021, it was quite obvious that small cap was attractive because of the historic, long-term outperformance,” he says. Beyond the return premium, smaller companies have several characteristics that can make them attractive to long-term investors. They tend to be more dynamic, Sjo argues, while the relationship between boards and management can be closer. Ownership structures can also be more aligned with long-term value creation. “Quite often there is a major shareholder that is very value-oriented, whereas large caps can have more stakeholders to satisfy.”
“Before 2020, 2021, it was quite obvious that small cap was attractive because of the historic, long-term outperformance.”
Jarle Sjo, Head of Research at Norcap AS.
Sjo also sees flexibility as an important advantage. Smaller companies can change direction more quickly when economic or industry conditions shift. “Small companies can do better in more challenging times because they are more nimble and can change their business model much more quickly,” Sjo argues. These characteristics supported the traditional case for small caps. But the emergence of AI and the dominance of technology companies have changed the relative picture. “The last five years, large caps have done better than small caps, especially globally,” Sjo says.
The technology cycle may eventually broaden
Sjo draws a parallel between the current AI investment cycle and the technology boom of the late 1990s and early 2000s. In the early phase of that cycle, infrastructure providers captured much of the value created by rapidly expanding technology investment. “If you compare this technology boom with what we saw around 2000, it was mainly the infrastructure companies that performed in the early stages of the technology revolution,” he says.
The next phase, however, brought a broader group of companies that used that infrastructure to develop new business models. Sjo points to companies such as Airbnb, Uber and Facebook as examples of businesses that benefited from the infrastructure built during the earlier technology cycle. He sees a similar possibility emerging from today’s AI investment. “This could create attractive opportunities in small caps.”
“The technology sector is a smaller sector in the Nordics than globally, so you need to see the benefits of technological change come through in other industries.”
Jarle Sjo, Head of Research at Norcap AS.
That does not amount to a call for an imminent rotation. Rather, Sjo sees the development of applications and businesses built on AI infrastructure as a potential longer-term source of opportunities outside today’s mega-cap winners. For Nordic small caps, however, the transmission mechanism may be less direct. “The challenge with the Nordics is how they will adapt to new technology,” he says. “The technology sector is a smaller sector in the Nordics than globally, so you need to see the benefits of technological change come through in other industries.”
Small caps also carry specific risks
The structural advantages of smaller companies come with vulnerabilities, particularly when financial conditions deteriorate. Historical studies, he notes, suggest that small caps can perform particularly poorly as an economy moves towards recession, before recovering strongly afterwards. Sjo points to leverage as one of the most important vulnerabilities. “Looking at the negative sides, small caps tend to have more debt than large caps, and that is probably the main risk,” he says. Although some large companies have also increased their leverage, smaller companies can have less room to absorb higher financing costs or a downturn in demand.
“Large caps tend to have more diversified global operations, whereas small caps in the Nordics can be heavily reliant on individual markets, suppliers or customers. That makes the current environment particularly challenging.”
Jarle Sjo, Head of Research at Norcap AS.
Geopolitical risk and deglobalization add another layer of uncertainty. This is particularly relevant in the Nordics, where many small companies are export-oriented. “It’s difficult to quantify that kind of risk, but small caps are more exposed than large caps,” considers Sjo. “Large caps tend to have more diversified global operations, whereas small caps in the Nordics can be heavily reliant on individual markets, suppliers or customers. That makes the current environment particularly challenging.”
How Norcap builds its small-cap exposure
Norcap maintains a diversified equity allocation for its wealth-management clients, with approximately 75 percent allocated to global equities, 15 percent to Norwegian equities and 10 percent to Nordic equities. Within the global allocation, the firm has a strategic target of 10 percentage points in global small caps. The Norwegian equity allocation is entirely invested in small caps, while approximately half of the Nordic allocation is allocated to the segment.
Given Norcap’s relatively small organization, the firm primarily builds these exposures through external managers, using both active and passive strategies. For global small caps, it works with Mercer to select five top-rated managers. Sjo, who has more than 30 years of experience in fund management and manager selection on the Nordic equity side, handles the Nordic manager selection internally.
Sjo says the small-cap managers selected through Mercer have collectively outperformed their market over the past decade, whereas finding consistent active outperformance in the broader Nordic equity universe has proved more difficult. As a result, Norcap combines active Nordic managers with passive exposure.
Manager selection matters more than the label
Norcap’s approach to selecting external managers is grounded in a long-term assessment rather than recent performance. Sjo identifies five main criteria, including track record, risk, team quality, decision-making structure and cost.
“We need to see 10 years of performance, so we tend to avoid any funds that have a shorter history than 10 years,” he says. Historical returns are only the starting point, however. The team also examines the level of risk taken to generate those returns and how consistently the manager has delivered through different market environments.
“We spend a lot of time on price. We avoid the high-cost funds because that will reduce the performance going forward.”
Jarle Sjo, Head of Research at Norcap AS.
The people behind the strategy are equally important. Norcap spends considerable time assessing the quality and structure of the investment team, including who ultimately makes the key decisions. Cost is the final consideration. “We spend a lot of time on price,” Sjo says. “We avoid the high-cost funds because that will reduce the performance going forward.”
The key question is what happens to the mega-caps
The valuation argument for small caps is compelling at first glance. Years of relative underperformance have left many smaller companies trading at substantial discounts to large caps. But Sjo is reluctant to use the valuation gap as a standalone reason to increase exposure. “I’m very careful about making an investment decision based on the price-earnings gap between small caps and large caps,” he notes. “The earnings growth of the large caps is still fantastic these days.”
“I’m very careful about making an investment decision based on the price-earnings gap between small caps and large caps. The earnings growth of the large caps is still fantastic these days.”
Jarle Sjo, Head of Research at Norcap AS.
For Sjo, there is no single catalyst that would guarantee a rotation from large to small caps. The more important question is whether the forces driving mega-cap outperformance remain intact. “The large-cap outperformance is obviously driven by technological development,” he says. “If this trend continues, then it’s difficult for small caps to outperform large caps.”
At the same time, he sees the technology transition itself as a potential source of opportunity for smaller companies. As AI infrastructure becomes more widely available, new businesses may emerge around its applications, potentially broadening the beneficiaries beyond today’s technology leaders. “That would probably be the main factor going forward.”
