Small Caps Outperform as LLY Nears a Critical Juncture: 5 High-Conviction Buys in a Shifting Market

The U.S. equity market is undergoing a structural shift in 2025, marked by a pronounced rotation into small-cap stocks and a reevaluation of sector dynamics driven by macroeconomic tailwinds and thematic catalysts. At the heart of this transformation lies Eli Lilly (LLY), whose meteoric rise in the GLP-1 drug space has not only reshaped investor sentiment in healthcare but also amplified broader momentum trends favoring small-cap equities. As the Federal Reserve signals a rate-cutting cycle and domestic policy tailwinds gain traction, small-cap stocks-long sidelined by large-cap dominance-are reclaiming their role as engines of growth. This article identifies five high-conviction small-cap stocks poised to capitalize on these market dynamics, with a focus on sectors directly or indirectly influenced by LLY's trajectory.

The Case for Small-Cap Outperformance in 2025

According to a Bloomberg report, the Russell 2000 index has outperformed the S&P 500 in 2025, driven by a combination of lower borrowing costs, attractive valuations, and improved earnings momentum. The Federal Reserve's pivot toward easing monetary policy has disproportionately benefited small-cap companies, many of which rely on floating-rate debt and operate in sectors sensitive to interest rate changes. Additionally, small-cap stocks trade at a 20% discount to large caps on a forward earnings basis, making them compelling value plays in a market increasingly focused on earnings growth.

The momentum rotation is further supported by ETF flows. After months of outflows, small-cap ETFs like the iShares Russell 2000 ETF (IWM) have attracted capital in Q4 2025, reflecting a shift in investor positioning. This trend is amplified by LLY's performance: its $1 trillion market cap milestone and blockbuster GLP-1 sales have drawn attention to healthcare innovation and, by extension, small-cap players in adjacent sectors.

LLY's Role in the Momentum Rotation

Eli Lilly's recent surge-33% year-to-date in 2025-has been fueled by the explosive success of Mounjaro and Zepbound, which generated $10 billion in combined sales for the third quarter. The company's upgraded revenue guidance and aggressive expansion into oral GLP-1 therapies have not only justified its 49.9x price-to-earnings ratio but also spurred broader interest in the GLP-1 space. This momentum has spilled over into small-cap ETFs, particularly those focused on pharmaceuticals and biotechnology, as investors seek exposure to innovation-driven growth.

However, LLY's valuation is a double-edged sword. While its dominance in GLP-1 drugs positions it as a bellwether for the sector, its high multiple leaves it vulnerable to production bottlenecks or competitive pressures from rivals like Novo Nordisk. This creates an opportunity for smaller, more agile players in the GLP-1 ecosystem to capture market share.

5 High-Conviction Small-Cap Buys in a Shifting Market

1. Limbach (LMB): Reshoring and Industrial Services

Limbach, a provider of industrial services, has demonstrated robust financial performance, with operating margins expanding by 6 percentage points over five years and EPS growth of 42.5% in the past two years. The company benefits from the U.S. reshoring trend, which is accelerating demand for domestic infrastructure and manufacturing support. As the Biden administration's infrastructure bill gains traction, Limbach's expertise in energy and industrial projects positions it to capitalize on long-duration growth.

2. Nicolet Bankshares (NIC): Financials and Interest Rate Sensitivity

Nicolet Bankshares has seen 18.5% annual net interest income growth over the past five years, with projections of 33.8% growth in the next 12 months. As a regional bank, NIC is highly sensitive to the Fed's rate-cutting cycle, which is expected to reduce borrowing costs and improve net interest margins. Its focus on commercial lending and community banking aligns with the broader small-cap rally, where financials are among the most attractive sectors due to their earnings visibility.

3. Babcock & Wilcox Enterprises (BW): AI and Energy Transition

BW has secured a $1.5 billion contract with Applied Digital for AI-driven data center projects. This aligns with the growing demand for AI infrastructure, a trend that has already benefited large-cap tech firms but remains underexplored in small-cap energy and industrial stocks. BW's pivot to AI-powered solutions for power generation and grid modernization positions it to benefit from both the energy transition and the AI boom.

#### 4. Innodata Inc. (INOD): AI Data Engineering
INOD is a key player in the AI data engineering space, with five of the "Magnificent 7" companies increasing their 2025 AI-centric capital expenditures. The company's GenAI Test and Evaluation Platform addresses a critical bottleneck in AI development-high-quality training data-and is expected to deliver 24.1% revenue growth in 2025. As AI adoption accelerates, INOD's niche expertise in data annotation and model training could make it a hidden gem in the sector.

5. Viking Therapeutics (VKI): GLP-1 Innovation

While not explicitly named in the research, companies like Viking Therapeutics are exploring oral GLP-1 alternatives and expanding into obesity treatment indications. These firms stand to benefit from LLY's market leadership in the GLP-1 space, as demand for innovative therapies grows. Viking's pipeline, which includes oral formulations of GLP-1 analogs, could position it as a long-term beneficiary of the sector's expansion, even as LLY's dominance faces competitive pressures.

Conclusion: Navigating the Momentum Rotation

The 2025 market environment is defined by a confluence of factors: rate cuts, reshoring, AI adoption, and sector-specific innovation. Small-cap stocks, with their agility and exposure to these trends, are uniquely positioned to outperform. Eli Lilly's rise in the GLP-1 space has not only validated the sector's potential but also highlighted the importance of thematic investing in a market increasingly driven by momentum. The five stocks outlined above-Limbach, Nicolet Bankshares, Babcock & Wilcox, Innodata, and Viking Therapeutics-represent a diversified approach to capturing the opportunities in this shifting landscape. As LLY approaches a critical juncture in its growth trajectory, investors would be wise to look beyond the headlines and focus on the small-cap innovators poised to ride the next wave of momentum.