After a rough few years, do small caps have room to grow again?

The gain in value for large companies' stock has lapped that of smaller firms in the past three years — to the tune of negative annualized returns on one side and growth on the other.

Asset managers specializing in small-cap investment funds who spoke at last week's Morningstar Investment Conference in Chicago admitted that the large companies' equity had, as one panelist put it, left "small caps in the dust" in recent years amid the earnings of the largest technology companies. Still, Morgan Peck, a portfolio manager with Fidelity Investments, Don San Jose, the chief investment officer of the U.S. Value Team with JPMorgan Asset Management, and Keith Lee, the CEO of Brown Capital Management, argued that the historical compelling case remains in place for the outperformance of undervalued smaller firms that produce fast-expanding profits lines before they've generated a lot of headlines.

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The innovations led by small-cap companies are "not changing, and that will come back," Lee said, noting that the rising price of stock in information technology firm Super Micro Computer has fueled a large portion of the albeit paltry overall increase in the Russell 2000 Index this year. That common benchmark for small-cap investments has climbed just 0.86% through July 1 — compared to 14.79% for the S&P 500.

"And if you didn't own that, that's what doomed a lot of small-cap managers," Lee said. "When companies like that perform and do well, then they're known names. People feel comfortable in them. They see it as being less risky than an investment in small companies. Small companies will do well again. I'm not in the business of making predictions of when and what time down to the second, but, if you're an investor, small companies are an exciting place to be."

Small-cap stocks occupy an important position in many client portfolios. A pioneer of the asset class, Dimensional Fund Advisors has won the same level of admiration in some financial advisor circles as names that are more familiar to the general population like Vanguard, Fidelity, BlackRock and State Street Global Advisors. The top-performing ETFs and other funds in the small-cap category netted annualized returns of nearly 14% over the past decade.

However, the so-called Magnificent Seven stocks — Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla — have been pushing the S&P 500 and other large-cap indices far above those of smaller companies in the past three to five years. For the 36-month period ending July 1, the S&P Global LargeCap index grew at an annualized rate of 4.47%, while the S&P Global SmallCap 600 dropped by 2.41% — a difference of 688 basis points. Using the Russell 2000 and the S&P 500 over the same span, the disparity was even higher: 1,134 bps.

The small-cap managers won't be giving up on their approach anytime soon, though. Lee's firm targets "exceptional growth companies" that have less than $500 million in operating revenue, and his team's portfolios "generally are tilted towards technology and health care" even though they're "finding value across the board," he said.

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Peck cited "a lot of opportunities globally" in the United Kingdom in all sectors and Japan in industrial and consumer-based industries, as well as in the U.S. industrial, consumer discretionary spending and regional banking businesses. The "quality-owned" ranks of regional banks with solid underwriting histories and "prudent capital management" hold appeal based on values that are still hurt by last year's regional banking crisis, she noted.

San Jose's team evaluates the management approach and business models of companies that could be potential investments in its funds, he noted. Building products present possibilities for investors, "especially with the potential for rates to ease up a bit," he said.

"For us, high quality is really what we focus on," San Jose said. "Even some of the banks look interesting, just given valuations."

Moderator Tony Thomas, the associate director of equity strategies for Morningstar Research Services, brought up a conversation he had with some colleagues recently in which they were building equity portfolios. Thomas' colleagues "only wanted to allocate 2% to small caps" based on what they viewed as the superior outlook for large-cap firms, he noted.

"They just have such a competitive advantage — their size, their scale, their resources," he said. "What is the competitive landscape like for small caps? How have those competitive advantages changed over time?"

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In general, smaller companies face a "tougher" challenge, Peck acknowledged. That doesn't mean there are no worthwhile investments in the asset class, she said.

"We're trying to find, and we are able to find, many companies that are adaptive and resilient, who are able to compete against large caps or they're able to find some small niche that they do incredibly well," she said. "They're in a market that is too small for these large companies to care about. There is no lack of ideas or opportunities across sectors."

San Jose's team of active managers is "out there finding companies" that are boosting their profit margins by 30, 50 or 100 basis points a year, he said. "There are opportunities for small caps, you just have to find them in these various niches."

Lee bluntly said Thomas' Morningstar colleagues who called for the 2% allocation were simply wrong. "I think that they should be looking for another job," he said.