How AI Is Creating Big Opportunities for Select Small-Cap Companies —Royce
article 05-28-2024

How AI Is Creating Big Opportunities for Select Small-Cap Companies

Portfolio Managers Jim Stoeffel, Brendan Hartman, Jim Harvey, and Assistant Portfolio Manager Kavitha Venkatraman detail how our Small-Cap Opportunistic Value Strategy is investing in several areas poised to benefit from the development of Artificial Intelligence.


The rapid development of Artificial Intelligence (AI) is perhaps the biggest technological change since the open Internet. Much of the focus is currently on mega-cap names—and the question of which of them will gain the lion’s share of the AI spoils. How many trillions of graphics processing units (GPUs) is Nvidia going to sell? Will anyone narrow their technological lead? Which of the mega-cap data center providers will win the fight for market share or the battle to provide the necessary High Bandwidth Memory (HPM)? How many household names—and new acronyms—might this technology spawn?

As is often the case with new technologies, small-cap companies tend to proliferate in the background of the megatrend. Nonetheless, they will be meaningful players as they are providing—or will ultimately provide—many of the products and services supporting the buildout of a vast AI infrastructure. And as we often say, we hold companies that will deliver the necessary picks and shovels. In fact, the discussion below represents just a portion of the opportunity we are seeing and does not begin to address the impact that AI will have on driving operating efficiencies in many portfolio names. It should, however, give a flavor of how excited we are about the opportunities for active small-cap investors by the rapid progress of AI.

Much of this opportunity will be somewhat direct. Fiberoptics companies such as Applied Optoelectronics, Coherent, and Infinera are poised to provide much of the fiberoptics componentry necessary for these massively high-powered data centers. Modine Manufacturing will provide more mundane, but no less critical infrastructure, such as high-technology cooling equipment. In order to produce the semiconductors needed to support AI, we expect to see another leg up for semiconductor equipment companies. Our portfolio has a number of niche competitors in this space, including FormFactor, Onto Innovations, and Ultra Clean Holdings. While these may be niche players, they are at the same time critical suppliers.

One of the increasingly discussed phenomena around AI’s development is the intense power demand. When combined with the increased need for electricity for electric vehicles (EVs), power demand looks like a related long-term investment thesis that fits our opportunity to buy key suppliers. This is a broad opportunity set, one that could be a topic in and of itself. However, to give a synopsis—it encompasses engineering & construction companies such as Matrix Service, Primoris Services, and Argan, secondary product suppliers such as WESCO International and Newpark Resources, direct energy suppliers, such as BWX Technologies, and data center providers like Applied Digital. Furthermore, this energy will need to be fueled somehow, and despite its currently depressed commodity price, we expect in the intermediate term that this need result in the increased use of natural gas. We see Archrock, which specializes in natural gas compression services & equipment, Southwestern Energy, an exploration & production business, and Patterson-UTI Energy, which offers drilling services, all as likely beneficiaries.

Finally, we see opportunities in securities that we believe have become mispriced due to concerns about the impact AI may have on their business models. WNS Holdings, Grid Dynamics Holdings, TaskUS, and DHI Group are all in the technology services industry where there are fears of disintermediation. We agree that AI is going to be disruptive. Yet if past is prologue, many of these companies can actually benefit, provided they can help longstanding clients embed and efficiently use AI capabilities. It was no surprise to us that several of these companies issued incrementally positive forecasts on their clients’ IT spending in their respective 1Q24 earnings releases.

We are hopeful for more positive news for all of the companies discussed in the months and years ahead.

Important Disclosure Information

Average Annual Total Returns as of 3/31/2024 (%)

NET               GROSS
Small-Cap Opportunity 5.16 18.66 2.94 14.13 8.82 11.99 11/19/96  1.23  1.23
Russell 2000 Value
2.90 18.75 2.22 8.17 6.87 8.96 N/A  N/A  N/A
Russell 2000
5.18 19.71 -0.10 8.10 7.58 8.28 N/A  N/A  N/A
1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Current month-end performance may be higher or lower than performance quoted and may be obtained at Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Mr. Stoeffel’s, Mr. Hartman’s, Mr. Harvey’s, and Ms. Venkatraman’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

Percentage of Fund Holdings As of 3/31/24 (%)

  Small-Cap Opportunity

Applied Optoelectronics


Coherent Corp.


Infinera Corporation


Modine Manufacturing




Onto Innovation


Ultra Clean Holdings


Matrix Service


Primoris Services




WESCO International


Newpark Resources


BWX Technologies


Applied Digital




Southwestern Energy


Patterson-UTI Energy


WNS Holdings


Grid Dynamics Holdings


TaskUS Cl. A


DHI Group


Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. The Russell 2000 Value and Growth indices consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap and micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund’s broadly diversified portfolio does not ensure a profit or guarantee against loss.



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