The current stock market presents a rare investment chance you won't see again soon. Discover how you can get involved.

The past ten years have been remarkably favorable for those investing in stocks. The S&P 500 ( ^GSPC 0.85%) has delivered a total return of over 300% since September 2015. Meanwhile, the technology-focused Nasdaq Composite index ( ^IXIC 0.72%) has performed even better, posting gains of more than 400% in the same timeframe.

However, this surge hasn't benefited all stocks equally. The largest corporations have expanded further, leaving smaller companies trailing. This trend can be observed in the S&P 500's unprecedented concentration, as well as in the weaker results from small- and mid-cap stocks. For instance, small-cap indices like the Russell 2000 and S&P 600 have increased by only 142% and 155%, respectively, during that period.

This divergence may have opened up a rare, significant opportunity for investors. Historically, small-cap stocks tend to outperform their large-cap counterparts, but these cycles are highly variable, lasting anywhere between five and sixteen years. Present indicators suggest we could be nearing the close of a lagging cycle, with small-cap stocks potentially taking the lead in the years ahead. Applying a simple filter when picking stocks could further enhance your returns.

A reversal of fortunes

In the past decade, the Russell 2000 has trailed the S&P 500 by an average of 5.8% per year, marking one of the most significant 10-year underperformances for small-cap stocks in history.

Although the Russell 2000 was established in 1984, Distillate Capital has reviewed returns for the middle 40% of stocks versus the top 30% going all the way back to 1935. At no point have smaller companies posted a 10-year annualized return gap below -6%. The analysts commented, "In previous periods when returns were similarly weak, the trend reversed, leading to multiple years of notable outperformance by smaller stocks."

The last time such a return gap appeared was during the height of the dot-com bubble. When the bubble burst, large-cap stocks experienced most of the losses, but small-cap stocks were relatively resilient. Between 2000 and 2009, the Russell 2000 achieved an average annual return of 3.51%, while the S&P 500 actually posted an average annual loss of 0.95%.

Importantly, small-cap stocks don't necessarily need a severe bear market to outperform after a period of underperformance. They also beat large-caps during the late 1950s and 1960s when the S&P 500 was delivering strong results.

Still, simply betting on a reversal isn’t a sufficient reason to invest in small-caps. There is another compelling historical factor that makes small-caps especially attractive at this moment and suggests a shift may be coming soon.

The market is offering a bargain price

Much has been said about the high valuation of the large-cap index nowadays. With a forward price-to-earnings ratio of 22.2, the S&P 500 is trading at a historically elevated level. In contrast, small-cap stocks—especially those that are profitable—currently present excellent value. The S&P 600, which only includes companies that consistently generate profits based on generally accepted accounting principles (GAAP), trades at just 15.7 times expected future earnings.

This means the S&P 600's valuation is only 70% that of the S&P 500. The last time this valuation gap was so wide was in 1999, which was also the previous low point for small- and mid-cap stocks in these performance cycles relative to large-caps.

It's important to note that the Russell 2000 does not currently offer as compelling a valuation. In fact, since 2020, its valuation premium over the S&P 600 has grown sharply after a steady rise that began in 2013. This highlights the importance of picking high-quality small-cap stocks.

The S&P 600 applies a straightforward GAAP profitability requirement, which has led to its outperformance over the Russell 2000 by a large margin during the past three decades. Research from Distillate Capital indicates that using positive free cash flow as a selection filter is also highly effective for identifying quality small- and mid-cap stocks. In fact, Russell 2000 companies with positive free cash flow have consistently outpaced the broader index, regardless of market conditions.

Therefore, you can benefit even more from the current market situation by focusing on small-cap stocks that show steady profits or generate positive free cash flow. One top choice for accessing high-quality small-caps is the Avantis U.S. Small Cap Value ETF ( AVUV 1.63%). The fund manager screens Russell 2000 companies based primarily on their cash flow to book value ratio as a measure of value. For financial sector stocks, it relies on adjusted net income to book value, reflecting the unique accounting practices of those companies. This approach ensures the portfolio is made up exclusively of quality stocks.

While investors will incur a slightly higher expense ratio with this ETF (0.25%), the superior returns from quality small-cap stocks often justify the cost. If you prefer a purely index-based approach, there are also ETFs that track the S&P 600 at a lower expense ratio. Keep in mind, however, that small-cap funds generally encounter higher tracking errors due to lower liquidity. No matter which route you take, the current climate offers a compelling case for considering small-cap stocks.