Baron Capital Sees Renaissance for Small-Cap Stocks: Attractive Valuations and Secular Trends Fuel Growth

Baron Capital, a renowned investment firm with a notable history of early investments in companies like Tesla, is predicting a significant resurgence for small-cap stocks. Driven by compelling valuations, supportive secular trends, and their own extensive research, Baron Capital managers believe that small-cap companies are poised for substantial gains. Their three funds—the Baron Growth Fund (BGRFX), Baron Small Cap Fund (BSCFX), and Baron Discovery Fund (BDFFX)—all boast significant small-cap exposures and have achieved impressive double-digit annualized returns since their inception, exceeding their respective benchmarks according to Morningstar data. This bullish outlook is fueled by the belief that current market conditions present a compelling contrarian investment opportunity.

Key Takeaways: Why Small-Caps are Poised for a Comeback

• Historically Low Valuations: Small-cap stocks are trading at their cheapest levels in 25 years, presenting a significant buying opportunity.
• Under-Ownership and Contrarian Indicator: Investor neglect of small-cap stocks, reaching a 10-year low in total growth exposure, signals a potential positive performance predictor.
• Tailwinds from Policy and Secular Trends: Domestic-focused, cyclical small-caps are expected to benefit from potentially favorable tax cuts and protectionist policies.
• AI-Driven Growth Opportunities: Baron highlights several small-cap companies leveraging artificial intelligence (AI) across various sectors, including cybersecurity and biotech.
• Data-Driven Businesses and the Sports Betting Boom: Companies proficient in proprietary data analytics and those capitalizing on the expanding sports betting market are seen as particularly promising.

Uncovering Undervalued Gems: The Baron Capital Approach

Baron Capital’s strategy emphasizes in-depth research and analysis to identify undervalued small-cap companies with robust competitive advantages. Portfolio manager Laird Bieger stated at the firm’s annual investment conference, “Small cap stocks are the cheapest they have been in the last 25 years. Small caps are under-owned by investors. Total small-cap growth exposure recently hit a 10-year low when investors are shunning the asset class. This could be a contrarian indicator and a positive predictor of performance in the future.” This highlights their belief that the current market undervaluation presents a unique opportunity.

The Power of Intensive Research

Another portfolio manager, Randolph Gwirtzman, emphasized the firm’s commitment to thorough research: “We find these stocks are under-followed and they’re under-researched. We do an incredible amount of research on these companies, which allows us to find small companies that can have great competitive advantage. So, we find hidden gems in this market.” This dedication to due diligence forms the cornerstone of their small-cap investment strategy, allowing them to uncover companies that may be overlooked by larger investment firms.

AI: A Catalyst for Small-Cap Growth

Artificial intelligence is a key theme driving Baron Capital’s optimism about small-cap prospects, with several of their holdings utilizing AI to enhance their products and services. The managers highlighted several examples:

SentinelOne: AI-Powered Cybersecurity

SentinelOne, a cybersecurity company, uses AI to bolster its network protection software, offering a competitive edge in a rapidly evolving landscape. The application of AI is viewed by Baron as a catalyst for significant growth potential within a critical sector.

Kratos Defense & Security Solutions: AI in Military Aviation

Kratos Defense is employing AI in the development of unmanned military jets, symbolizing innovation within the defense sector and creating opportunities for future growth through the application of advanced technology.

Tempus AI: Revolutionizing Cancer Diagnostics and Drug Development

In the biotech space, Tempus AI uses AI to improve cancer diagnostic testing and assists pharmaceutical companies in drug development. This illustrates AI’s potential to transform healthcare, providing a significant engine for growth for small-cap companies leveraging the technology.

Data Dominance and the Rise of Sports Betting

Beyond AI, Baron Capital identifies other key sectors within the small-cap universe with notable growth potential.

Proprietary Data Companies: Leveraging AI for Enhanced Value

Companies specializing in proprietary data, such as MSCI, Gartner, and CoStar, are seen as poised for growth. Gwirtzman noted, “We think AI is going to let them drive human insights from their growing data … it will also help them raise prices to reflect the greater value they deliver.” The increasing importance of data analytics across various industries positions these companies for continued expansion and value appreciation.

DraftKings: Capitalizing on the Expanding Sports Betting Market

The legalization of sports betting in various states is a significant tailwind for DraftKings, a leading online gambling platform. Baron believes that DraftKings’ stock “could more than double in the next five years,” reflecting the substantial market opportunity presented by the expanding sports betting industry.

The Baron Funds: A Proven Track Record

The Baron Growth Fund, Baron Small Cap Fund, and Baron Discovery Fund all demonstrate a consistent history of success, providing a degree of validation for the firm’s investment strategy. While these funds charge approximately 1.3% in fees, their double-digit annualized returns since inception and outperformance of their respective benchmarks, according to Morningstar data, showcase the potential for strong returns within the small-cap space. The long-term perspective and rigorous research undertaken by Baron Capital underpin this track record of success.

Conclusion: A Compelling Investment Case for Small-Cap Stocks

Baron Capital’s bullish outlook on small-cap stocks is based on a confluence of factors: historically low valuations, under-ownership by investors, positive policy tailwinds, the transformative potential of AI, and growth opportunities in data and sports betting. Their deep research methodology and proven track record further strengthen the case for a renaissance within the small-cap market. While investment involves inherent risk, Baron Capital’s analysis suggests that now presents a particularly compelling time to consider this often-overlooked segment of the equity market.