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For years, U.S. small cap stocks grossly underperformed their large-cap peers in the stock market. Earnings stumbled, margins lagged, and investors poured money into the megacap tech names that dominated the AI boom. But 2025 is shaping up differently. Improving fundamentals, historically cheap small cap valuations, and accelerating M&A activity are beginning to create conditions for a meaningful re-rating in the small-cap universe.
Here's what's behind the shift—and three small cap stocks that look increasingly compelling for those seeking investment opportunities in the smallcap 600 index.
Small-cap stocks typically defined as companies with market caps between $300 million and $2–3 billion, historically carry higher beta and outperform during periods of economic expansion. But the last several years broke that pattern, leading to significant small cap stock underperformance.
Small cap performance mirrored the fundamentals. Year-to-date, the Russell 2000, a key small cap index, is up about 10%, compared with 17% for the S&P 500, and the gap is even larger over the last two years. This underperformance has led to a widening risk premium in terms of risk-adjusted returns for small cap stocks.
But that performance deficit is exactly what sets up today's opportunity in the small cap strategy.
Strategists at State Street, BofA Securities, and Scotiabank highlight several structural catalysts that could drive a recovery in the smallcap universe.
Small-cap companies carry higher leverage and are far more exposed to floating rate debt. The average net-debt-to-EBITDA ratio in the Russell 2000 sits around 4.5x, compared with 1.5x for S&P 500 companies.
With the Federal Reserve already cutting rates twice in 2025, bringing the federal-funds target range down to 3.75–4%—and odds of another cut nearing 40%, the cost-of-capital environment is turning friendlier for small-cap balance sheets. This could potentially reduce the price fluctuations associated with small cap stocks.
Relative to large caps, small cap valuations are in their cheapest quintile in four decades.
Historically, when small caps fall into that bottom valuation bucket, they tend to outperform the broad market over 5- to 10-year horizons. The timing is unpredictable, but the long-term statistical edge is robust, potentially leading to higher return on investment for investors in small cap companies.
According to Jefferies, M&A involving publicly listed small caps is on pace to approach record levels last seen in the mid-1990s. Depressed company valuations make small companies attractive acquisition targets for both strategic buyers and private equity firms, and buyout premiums frequently boost returns for shareholders.
Acuitas Investments notes that investors ultimately return to businesses with high earnings-growth potential at discounted multiples, traits small caps increasingly exhibit. This trend could lead to increased liquidity in the small cap market and attract more investment capital.
Below are three companies that, according to 8FIGURES AI Investment Advisor, combine improving fundamentals, attractive small cap valuations, and strong long-term positioning in their respective markets. These small-cap companies exemplify the potential investment opportunities in the current market environment.
Yelp remains one of the leading U.S. platforms for local service discovery, built on more than 280 million user reviews. Its core business is advertising sold to local merchants—mostly small and mid-sized businesses—using a cost-per-click model.
The company is increasingly layering artificial-intelligence features on both the consumer and merchant sides: smart assistants, automated receptionist tools, and higher-precision ad targeting.
While Yelp still faces intense competition from Google Maps, DoorDash, OpenTable, and other vertical marketplaces, its strength lies in verified, structured, and moderated reviews, which remain a key element in consumer decision-making. Surveys consistently show:
Advertising remains the growth engine, with services categories (home, auto, beauty, health, etc.) showing strong pricing power: average cost-per-click rose 14%, even as click volume fell due to macro softness.
Yelp's partnership with RepairPal contributed roughly 2 percentage points of ad-revenue growth.
Operating discipline is improving:
Yelp maintains a debt-free balance sheet with $231 million in cash. It continues executing a sizeable buyback program launched in 2017—over $1.85 billion repurchased so far—with about $100 million remaining.
Shares are down nearly 20% year-to-date as consumer spending softened, pushing valuations well below peers and Yelp's historical averages.
Yet the business fundamentals—steady top-line growth, expanding margins, healthy cash flows—suggest an underappreciated recovery story. For long-term investors, Yelp looks attractively positioned in the small cap space, offering potential for significant return on investment.
Pagaya operates an AI-driven infrastructure layer for banks, fintechs, auto lenders, card issuers, and point-of-sale platforms. Its underwriting algorithms process vast volumes of loan applications—more than $3.2 trillion cumulatively—identifying creditworthy borrowers traditional models often miss.
Roughly 42% of Americans are declined for credit under conventional scoring models; Pagaya helps lenders convert more applicants without raising risk. Approved borrowers on the platform have an average income of around $110,000, highlighting the quality of the credit pool.
Pagaya partners with institutions such as SoFi, Ally, U.S. Bank, and Klarna through 30+ integrated APIs. Importantly, the company does not keep loans on its own balance sheet: instead, it pre-arranges institutional capital (including ABS buyers), allowing unlimited scalability without assuming credit risk.
This model has made Pagaya one of the largest ABS issuers in the U.S. consumer-lending space, with more than $31 billion raised from 150+ institutional investors.
The strongest growth came from Network AI fees and a 19% increase in total loan volume processed.
Operating income is solidly positive; operating margin reached 22.8%, a record for the firm.
Operating cash flow for the trailing 12 months hit $205 million, up from $66 million in 2024.
Capex remains minimal due to the asset-light nature of the business.
Pagaya does not currently pay dividends or conduct buybacks, opting to reinvest in platform expansion.
Despite rising profitability and leadership in AI-driven credit infrastructure, Pagaya still trades below its historical multiples and peers in fintech infrastructure.
For investors seeking exposure to the intersection of AI and financial services, without the balance-sheet risks typical of lenders, Pagaya represents a compelling long-term idea in the small cap market, with potential for significant market capitalization growth.
SoftwareOne is one of the world's largest resellers of software and cloud solutions, serving more than 65,000 customers across 70 countries. It acts as an end-to-end IT partner, helping companies buy, manage, migrate, secure, and optimize software and cloud infrastructure.
Its three major segments include:
Structural IT trends—cloud migration, multi-cloud complexity, cybersecurity demands, and rapid AI adoption—play directly to SoftwareOne's strengths. The company maintains partnerships with 7,500+ software vendors, including Microsoft, Adobe, AWS, Google Cloud, Oracle, and ServiceNow.
In 2025, SoftwareOne won a major contract to support German federal IT systems with Microsoft solutions—potentially worth up to €1.5 billion over four years—cementing its status as a key partner for large public-sector deployments.
Cash generation is a standout:
SoftwareOne trades at a deep discount to peers in IT distribution and cloud services, largely due to concerns over Microsoft's incentive-program changes in 2024—which the company believes have now largely normalized.
Given SoftwareOne's global reach, sticky enterprise relationships, and pivot toward higher-margin service lines (cloud, AI, FinOps, cybersecurity), the current valuation appears overly pessimistic. For investors seeking international diversification within the small-cap IT space, the stock offers an appealing mix of value and recovery potential.
Small cap stocks won't close the performance gap with megacaps overnight, especially while AI hyperscalers continue to dominate S&P 500 earnings. But the ingredients for a multi-year resurgence are falling into place:
For investors with a 3- to 10-year horizon, the small-cap universe finally looks interesting again. And companies like Yelp, Pagaya, and SoftwareOne show how select opportunities are emerging well before the broader market narrative catches up.
If you've been underweight small caps, 2025 may be the moment to start building exposure, before everyone else notices. The current economic uncertainty and cyclical factors could present a unique opportunity for investors to capitalize on the potential outperformance of small cap stocks in the coming years.
As the public markets continue to evolve, small cap companies face both opportunities and challenges. While disclosure requirements and regulatory burdens can be significant for smaller listed companies, the potential for growth and value creation remains strong. Asset management firms are increasingly looking at the small cap space for alpha generation, recognizing that these companies often have more room for expansion compared to their large-cap counterparts.
It's important to note that small cap investing comes with its own set of risks. These stocks can be more volatile than large caps, and some may even fall into the category of penny stocks, which are known for their extreme price fluctuations. However, for those willing to navigate the complexities of small cap investing, the rewards can be substantial.
In conclusion, as the landscape of both public and private markets continues to shift, small cap stocks are presenting an intriguing opportunity for investors. With favorable valuations, improving fundamentals, and the potential for significant growth, now may be the time to consider increasing exposure to this often-overlooked segment of the market.
REFERENCES
1. SoftwareOne Holding AG, Half-Year Report 2025 (Stans, Switzerland, 2025), https://report.softwareone.com/hyr25/app/uploads/Half-Year-Report-2025-en.pdf.
2. Pagaya Technologies Ltd., Investor Presentation (Form 6-K Exhibit, 2025), https://investor.pagaya.com/static-files/fb64c896-49a2-4151-b3f5-9c47d19d9375.
3. Yelp Inc., “Yelp Reports Third Quarter 2025 Results,” press release, November 2025, https://www.yelp-ir.com/news/press-releases/news-release-details/2025/Yelp-Reports-Third-Quarter-2025-Results/default.aspx.
4. PitchBook Data, Inc., Q2 2025 Global Private Market Fundraising Report (Seattle, WA: PitchBook, 2025), https://pitchbook.com/news/reports/q2-2025-global-private-market-fundraising-report.
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