U.S. small-cap stock performance is soaring in the second half of 2025, with the benchmark S&P Small Cap 600 Index up 10.7% in the last three months and up 4.1% over the past 30 days. The broader large-cap S&P 500 Index is up just 8.9% and 1.8% over the same time periods.
Small-caps should rise even further if, as expected, the Federal Reserve cuts interest rates at the Fed's Open Markets Committee in mid-September. A .25% cut in the benchmark federal funds rate is a “done deal,” according to a Reuters survey of 107 economists, which would be good news for U.S. small-cap companies looking for lower credit and borrowing rates.
“Lower rates would impact small-caps more directly through lower borrowing costs, given small-caps are more reliant on debt financing,” said Dan Skubiz, senior portfolio manager at F/m Investment. “Lower interest rates would reduce interest expense and improve relative earnings power.”
34 Straight Wins: The Income Strategy That Loves Market Crashes
While others lost money on volatility, Tom Gentile collected as high as $1,925 in a single week. His 34-0 track record proves you can profit whether markets rise, fall, or go sideways. Learn the complete system. Reserve your free seat now.
But finding the small-caps that are worth investing in can be a challenge.
Small-caps are also more closely tied to the US economy. “If lower rates provide stimulus and US growth stabilizes or accelerates, small-cap stocks would see that get priced into stocks as they tend to outperform in the early to mid-stages of an economic expansion,” Skubiz added.
The Fed's big decision on rates also comes at a time when concentration levels in the S&P 500 have reached all-time highs this year, with over 40% of the S&P 500 weighting in 10 stocks.
“Since early August, we have seen a broadening out of the stock market, and small-cap stocks have outperformed the large-cap tech trade, which had been the prominent trend in the market since the April lows,” said Grace Glockner, CFA, and national accounts director at Scharf Investments. “Believers in the mean reversion theory would argue that this broadening out is likely to continue.”
A broadening of the market would further support this outperformance, Glocker noted. “However, if the Fed is cutting rates because the economy has materially weakened, small-cap stocks tend to respond quickly to cyclicality and would likely underperform in that environment,” she added.
3 Small-Cap Stocks To Play If Fed Cuts Heat Up The Economy
With myriad small-cap stocks to choose from, it's not easy to pick winners in a lower-rate environment. Start that due diligence process with these three small-cap names, market mavens say.
Patrick Industries
Year-to-Date Performance: 37.00%
Patrick Industries (NASDAQ:PATK), a supplier and distributor of components and materials to RV, manufactured housing, marine, and industrial OEMs, has successfully expanded margins during the demand downturn. “Lower rates should spur incremental volume growth in their end markets to add to growing aftermarket business and a successful M&A strategy,” Skubiz said.
Federal Signal
Year-to-Date Performance: 38.00%
Illinois-based Federal Signal (NYSE:FSS), a high-quality manufacturer of municipal and environmental equipment (such as street sweepers, vacuum trucks, and warning systems), has seen its share price skyrocket by 38% in 2025. Company backers say there's plenty more room for growth.
“Federal Signal's industrial customers will benefit from lower borrowing rates for their equipment. In contrast, their municipal customers benefit from infrastructure spending and a higher tax base from an improving economy,” Skubiz noted.
LKQ Corporation
Year-to-Date Performance: -10.42%
Antioch, Tenn.-based LKQ (NASDAQ:LKQ) is a vehicle parts and products distributor that should benefit from auto owners opting to extend the longevity of their cars and trucks in a period of sky-high vehicle prices.
“LKQ parts consistently show better longevity than cheap overseas alternatives,” said Howard Lutz, a former Toyota service manager and founder at Universal Inspections in Woodstock, Al. “Their salvage yard network creates a moat that’s nearly impossible to replicate.”
Lutz noted the automotive service sector is exploding as vehicles become more complex. “During my Toyota days, we saw 15-20% annual increases in diagnostic complexity,” he said. “Small-cap companies providing specialized diagnostic equipment or training programs are riding this wave as independent shops scramble to keep up with technology.”
Look To Funds, As Well
The small-cap realm is a great space to add value by using an external manager via mutual funds or active ETFs. That's especially the case as information asymmetry increases the further down investors go in terms of cap size; investment managers can earn their expense ratios by outperforming the index.
“Buying single stock positions in the small-cap space opens investors up to a lack of diversification within the most cyclical equity asset class, another reason that it pays to have a quality manager,” Glockner said. “Look for managers that emphasize quality companies at appropriate valuations, and when evaluating actively managed funds. Also look for managers that maintain close relationships with company management to monitor changing business.”
Editorial content from our expert contributors is intended to be information for the general public and not individualized investment advice. Editors/contributors are presenting their individual opinions and strategies, which are neither expressly nor impliedly approved or endorsed by Benzinga.
Photo: Shutterstock
