Disrupting the scale barrier
Traditionally, the biggest obstacle for small companies was the scale barrier. Because of the economies of scale, large companies could produce goods and services more cheaply than their small-cap counterparts. Now, with the cloud, cost savings can be achieved in a new way.
Companies can rent entire business functions in the cloud – manufacturing overseas, as well as legal, accounting, compliance, and IT from a variety of sources. As a result, large companies are less able to use their size to squash competition, and we’re seeing a new crop of small companies compete in markets previously reserved exclusively for the large players.
The cloud is also becoming an increasingly vital ingredient in how companies collect, analyze and store data. Meanwhile, AI is allowing companies to extract maximum value from this data by automating and optimizing business processes. Together, they are making innovation more valuable and far less expensive to pursue.
You don’t have to own it; you can rent it
A perfect example of where these trends come together is the software business. In the past, if a company wanted software, it was required to buy the application, load it onto its server, and maintain an IT staff to manage it. Now companies can simply rent software in the cloud.
For example, Pegasystems provides software that automates customer interactions. It gathers and stores customer data in the cloud, and it uses a form of AI machine-learning to seek ways to improve the customer experience.
When a client’s customer service representatives take a call, they can access all information on the customer’s accounts and interactions in the cloud. AI can make suggestions to help the rep determine the best course of action for the customer. Over time, these interactions become more efficient as the algorithm improves.
Another example is Arista Networks, which provides networking equipment that allows companies to customize their networks for the specific applications of their businesses.
Competing with Cisco Systems
In the past, Cisco Systems was the only dominant provider of networking equipment. But that has been changing amidst an increasing demand for custom network services. Since Cisco’s proprietary equipment does not accommodate customization of network services, Arista Networks has been able break through Cisco’s near monopoly to get a foothold in that market. Its programmable chips and open-source operating systems can be customized and improved over time.
These technologies are also empowering innovations in other sectors. In healthcare, the mapping of the genome in the late 90’s – enabled by increased computing power – has led to new drug development today.
There has also been a tremendous amount of investment in the biotech industry as a result. Gene therapy and immunotherapy in cancer treatment are examples of areas of large investment.
Catalent and Syneous Health both provide services to companies attempting to commercialize new drugs. If you’re a scientist and want to develop and commercialize a new drug, you don’t have to be a Merck or a Pfizer with armies of researchers and centralized business functions. You can procure capabilities from companies like Catalent and Syneous.
Why small cap?
Small-cap companies tend to carry higher risks and higher valuations than larger stocks, but the growth potential of the leading small-cap stocks far exceeds the potential of most of the larger, more established companies. Additionally, the advent of cloud computing and AI reduce the competitive barriers once enjoyed by large scale enterprises and gives the advantage to smaller more agile companies.
Within the small-cap universe, we try to find the companies with the potential for more durable growth compared with market expectations. We evaluate the risks that those companies face by looking beyond their current circumstances to understand what a company’s market opportunity and competitive advantage may be in future years.
We look not only at the management team and the capabilities of each company but also the potential size of the company’s market segment and its competition. It’s important not to extrapolate trends indefinitely, which is where our disciplined focus on valuation helps reduce the risk of overpaying for future growth.
AI and the cloud are likely to play a significant role in determining which small companies will go on to greater success and will be able to sustain growth over the long term. Recognizing their impact now – and knowing how to evaluate companies correctly – will be critical for small-cap investors over the next decade.