Here's a way to look beyond Nvidia's stock for AI investments

By Philip van Doorn

Jim Stoeffel and Brendan Hartman of Royce Investment Partners own stocks of companies that supply large makers of semiconductor-manufacturing equipment

Nvidia Corp. dominates coverage about the growth of artificial-intelligence hardware, and rightly so. But there are companies on the other end of the spectrum - small-cap and even microcap stocks - that might be less risky for investors looking to ride the AI and semiconductor wave in the stock market.

For Nvidia (NVDA), some investors or traders may have had a scare recently because the stock fell 16% from its record split-adjusted intraday high of $140.76 on June 20 through the close at $118.11 on June 24. Then it bounced 7% to close at $126.09 on June 25. The stock closed at $125.83 on Friday. All of this shows that a stock that has returned 154% so far this year can be volatile on any given day.

Nvidia is priced for rapid growth, with the stock trading at 22.5 times the consensus sales-per-share estimate for the next 12 months, among analysts polled by FactSet. That is the highest price/sales ratio for any company in the S&P 500 SPX, and compares with a weighted ratio of 2.8 for the full index.

Then again, Nvidia is quite profitable. Earnings per share for its most recently reported fiscal quarter ended April 28 were up 21% from the previous quarter and 629% from the year-earlier quarter. Meanwhile, its quarterly sales had jumped to $26.04 billion from $22.1 billion the previous quarter and $7.19 billion for the year-earlier quarter, as the company continued to dominate the new business segment that it essentially created last year: Installation of graphics processing units (GPU) by data centers to support their corporate clients' AI efforts.

A case can be made that Nvidia is not in a similar bubble to the cycle Cisco Systems Inc. (CSCO) and Intel Corp. (INTC) went through more than 20 years ago. Then again, we have no way of knowing how long Nvidia will continue to dominate the GPU space while continuing to innovate to stay ahead of competitors. And investors are facing increasing concentration risk from a company that now makes up 6.8% of the SPDR S&P 500 ETF Trust SPY.

Jim Stoeffel and Brendan Hartman of Royce Investment Partners are interested in a diversified set of investments in AI and the growth of the semiconductor industry. In an interview with MarketWatch, they described a "picks-and-shovels" approach to the expansion of data centers' computing infrastructure. Stoeffel and Hartman co-manage the $1.2 billion Royce Small-Cap Opportunity Fund RYPNX with Jim Harvey and Kavitha Venkatraman. The fund is ranked four stars (out of five) in Morningstar's "Small Value" fund category. There is more information about its composition and long-term performance below.

Royce Investment Partners, a subsidiary of Franklin Templeton, is based in New York and manages about $13 billion through several mutual funds. The team has been focused on small-cap and microcap stocks since the original partnership was founded in 1972.

The Royce Small-Cap Opportunity Fund's portfolio includes more than 200 stocks. Stoeffel said the fund wasn't correlated with any index because its average stockholding had a market capitalization well below that of small-cap index benchmarks and "significantly below our peers."

A standard benchmark index for small-cap stocks is the Russell 2000 RUT, along with the more selective S&P 600 Small Cap Index SML, which has requirements for initial inclusion that include four quarters of consecutive profits. The Russell 2000 has no such criteria, as it is made up of the smallest 2000 companies in the Russell 3000 RUA, which itself is designed to capture 98% of the U.S. market for publicly traded companies.

Stoeffel said that the primary valuation metric he and his colleagues use when selecting stocks for the Royce Small-Cap Opportunity Fund is the price-to-sales ratio, along with price-to-book, relative to particular industries or the companies' histories.

It was usually easy to determine through financial analysis why certain stocks were trading low by these measures. "Where active management comes in is to determine if that is a permanent state of affairs or if it is something that can be fixed," Stoeffel said.

He outlined four broad categories for companies the fund invests in:

Asset plays, which would be a focus on price/book value. A company may appear to be a bargain, selling for less than its net assets are worth.Turnaround plays.Undervalued growth.Interrupted growth.

With this approach leading to the selection of companies that are small even by the standards of the Russell 2000, "we have more volatility than you would expect to see in the benchmarks," Soeffel said. "We counter that with broad diversification."

Hartman said that, especially for microcap stocks, "concentration will kill you" because of volatility.

"If we have a particular investment theme, we will own four or five stocks because we want to get the theme right without taking specific risks," he said.

Hartman called the active component of managing such a large portfolio of companies "labor-intensive," including conversations with companies' management teams, analysis of quarterly financial reports and deep digging to "find out what is going on underneath the numbers."

"The key is finding out where we think the earnings power is significantly higher than the currently reported numbers," he said.

The fund tends to be heavily weighted to technology and industrial companies, which are "where we find the turnarounds and undervalued growth stocks," Hartman said. He added that "defense and aerospace companies, for example, have good operating leverage when things are fixed."

Four stocks for a combined theme - AI, semiconductors and reshoring

According to Stoeffel, there has been a consolidation of supply chains for large companies that make equipment used to design and manufacture semiconductors, including Applied Materials Inc. (AMAT), Lam Research Corp. (LRCX) and Tokyo Electron Ltd. (JP:8035).

Two companies held by the fund that supply subsystems and components to Applied Materials and Lam Research are Ichor Holdings Ltd. (ICHR) and Ultra Clean Holdings Inc. (UCTT). "Both companies have expanded through gaining market share by consolidating key subsystem areas - Ichor in gas panel products and Ultra Clean in chemical delivery systems," Stoeffel said.

"As the semiconductor equipment market accelerates from its recent slowdown and with new semiconductor use cases such as high bandwidth memory for Artificial Intelligence applications, we believe this will result in higher earnings power in the next upcycle," he said. He also said both stocks were trading between 11 times and 12 times their peak earnings per share, which he believes underscores their potential upside.

Repeating the "picks and shovels" theme, Hartman provided another interesting example - Applied Optoelectronics Inc. (AAOI), which makes optical components used for various purposes, including manufacturing. "Sometimes it is better to be lucky than to be smart. We owned it for other reasons, but then out of the blue they had a Microsoft contract for optical components," Stoeffel said, adding that Microsoft had supplied financing to Applied Optoelectronics.

Stoeffel said that when he asked Applied Optoelectronics Chief Financial Officer Stefan Murray how the company had landed a contract with Microsoft Corp. (MSFT), Murray said that the company was the only one that could manufacture the optical components Microsoft wanted in the U.S. Microsoft provided financing for needed equipment purchased by Applied Optoelectronics as part of that deal, which was announced quietly in a filing with the Securities and Exchange Commission in June 2023.

"This is part of the reshoring wave," Stoeffel said, referring to new construction of manufacturing facilities for semiconductors and other industries, funded in part by the federal government in response to shortages during the COVID-19 pandemic.

Shares of Applied Optoelectronics have been volatile, rising as high as $24.75 this year but closing July 3 at $8.17. Stoeffel sees this as a multiyear play, because "they have not generated much revenue" yet from the new Microsoft deal.

Then again, Microsoft was already the largest customer of Applied Optoelectronics before the June 2023 deal, and provided 46.6% of its $217.6 million in revenue for 2023. During 2022, Microsoft was Applied's largest customer and provided 18.4% of its $222.8 million in revenue.

"There will be billions spent on AI infrastructure, so we are early with this stock," Stoeffel said.

Another company held by the fund is Modine Manufacturing Co. (MOD), which made radiators for the auto industry, and then other types of thermal-management equipment. The company has been able to leverage its expertise to develop equipment to manage heat transfer for industrial electric vehicles [such as busses] and for trains, Hartman said.

The case for small-cap and microcap stocks now

An investment in hundreds of stocks in the small-cap and microcap space is by definition diversified from the S&P 500, which continues its bull run fueled by its heavy concentration in its largest components. Together, Microsoft, Apple Inc. (AAPL) and Nvidia make up 21% of the SPY portfolio. SPY has returned 17.6% this year, while Microsoft has returned 24.8%, Apple has returned 17.9% and Nvidia has returned 154.1%, all with dividends reinvested.

With hundreds of companies in the Russell 2000 index not showing profits, a comparison of valuations using price-to-earnings ratios might not be particularly useful. But we can look at forward price-to-sales ratios for index ETFs, which are weighted by market cap and based on consensus estimates among analysts polled by FactSet.

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07-08-24 1032ET

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