Small-Caps Are Poised to Climb, Baron Manager Says

Small-capitalization stocks have lagged large-caps over the past 10 years. But little brother is poised for a recovery, says Randy Gwirtzman, co-manager of Baron Discovery Fund  (BDFFX) – Get Free Report, composed of small-cap growth stocks.

As of June 29, the fund generated annualized returns of 12.78% for the past year, 5.41% for the past three years and 7.1% for the past five years, according to Morningstar. That compares with 16.28%, 7.59% and 4.54% for Morningstar’s small-cap growth-stock index.

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From its inception Sept. 30, 2013, through May 31, the fund returned 11.35% annualized, almost twice the 6.92% of the Russell 2000 Growth Index of small-cap stocks, according to Baron.

We recently chatted with Gwirtzman about his views of the small-cap market, including which industries he favors and a couple of his stock picks. Here are his comments.

TheStreet.com: What’s your investment philosophy?

Gwirtzman: We’re looking for secular, not cyclical, investments. We believe in long-term market inefficiencies. We look for companies with sustainable advantages. We’re looking for companies that can double their share price in five years, which means gains of about 15% annualized.

We want companies that haven’t deeply penetrated their markets, so there is a lot of room for them to grow. From a risk management perspective, we are careful about position size, valuations and industry allocation versus the Russell 2000 Growth index.

TheStreet.com: What makes small-cap attractive as an asset class?

Gwirtzman: There are a lot more inefficiencies in small-cap versus the others. Fewer people doing the work [research]. The companies are often misunderstood. Their market penetration tends to be low. Our tagline about small-cap companies is “you’ve never heard of them, but you will.” These are companies that could be the next Apple  (AAPL) – Get Free Report or Nvidia  (NVDA) – Get Free Report.

TheStreet.com: What’s your outlook for small-cap growth stocks near-term and long-term?

It feels like the Fed is closer to ending its tightening. Inflation is coming down quite a bit. Earnings estimates are coming down. We think unemployment will rise. Small-caps are priced for mild recession.

They are underpriced versus large-cap. The forward enterprise value-to-Ebitda ratio stands at 12.5 for small-cap versus 13.5 for large-cap. It’s typical for the small-cap ratio to be above large-cap.

Small-cap generally leads the market down going into recession and leads it up coming out of recession. Once investors get convinced we’re near the end of recession, stocks will likely anticipate that. Small-cap is in really good shape to outperform over the next six to 12 months.

This is an incredibly attractive asset class over the long term. There are great companies with organic growth. When you’re smaller, it’s easier to grow faster.

TheStreet.com: What industries are attractive for small-cap growth stocks now?

Gwirtzman: 1. Software. That includes cybersecurity, database software and application development software. In 2022, small-cap software stocks were inordinately hurt. There are great secular growth opportunities in the sector. The stocks also are at valuations we haven’t seen for a long time. You’re getting high-quality companies at bargain prices.

2. Semiconductors: analog chips used in auto end markets and power management. In autos, more efficient chips can be used throughout the vehicle, preserving battery power and increasing range in electric vehicles. As for power management, efficient chips can save energy in data centers and elsewhere.

3. Industrials: ones with protected high-end markets, such as defense.

4. Health Care: There are good opportunities, but you have to be careful picking individual companies. Valuations have held up better than other stocks in the market downturn. That’s because health care is less affected by the economic cycle.

TheStreet.com: Can you discuss two of your favorite stocks?

1. Indie Semiconductor  (INDI) . It produces semiconductors used in auto end markets. It designs mixed-signal chips They’re used for safety systems, power management and back-end user experiences, such as integrating your phone with the dashboard display.

They have sole-sourced contracts that last seven to 10 years. They will likely double their revenue in 2023 and can multiply their revenue by four over the next five years. The stock could go to $30 in 2027. [It recently traded at $9.35.]

2. Axonics  (AXNX) – Get Free Report. They make medical devices for incontinence. They have a terrific balance sheet, with no debt.

They have an implantable device like a pacemaker to combat urge incontinence, which occurs when you can’t control your bodily functions. The device sends pulses, which improve the patient’s situation.

There’s also stress incontinence, where physical force causes leakage of the bladder. This happens a lot to women post-childbirth. Some have such an issue that surgery is necessary. Axonics has an injectable drug, Bulkamid, that treats stress continence without surgery. This could be a $2 billion to $3 billion drug [in sales per year.]

Axonics’ revenue will likely average 25% growth over the next five years, and the stock could rise to $140. [It recently traded at $50.70.] 

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