Money manager recommends 3 small-cap growth stocks

For the last 10 years, large-cap stocks have outperformed small-cap stocks. So does that make small-caps a buying opportunity now?

Yes, says Bryan Wong, co-portfolio manager of the Osterweis Emerging Opportunity Fund  (OSTGX) - Get Free Report, a small-cap growth stock fund. It has an annualized return of 6.69% for the five years through Aug. 25, compared to a 2.83% return for the Morningstar U.S. Small Cap Broad Growth Index.

Wong says that along with international stocks, small-cap is one of the most neglected asset classes. Small-cap stocks are thinly covered by analysts and provide an essential element of a diversified portfolio, he says. Wong particularly likes the healthcare and technology sectors.

We recently asked him for his latest views. Here they are, including three stock picks.

TheStreet: What’s your investment philosophy?

Bryan Wong: We’re looking for exceptional small-cap growth companies that can graduate to mid-cap. We look for long-term performance, three to five years. We aim for 15% or better annual growth in earnings per share. We have a concentrated portfolio, with 30 to 40 positions. We have an absolute value discipline. We trim positions when values get elevated.

TheStreet: What’s the appeal of small-cap growth stocks?

There’s inefficiency in the small-cap market. Small-cap stocks have an average of four analysts covering each one. That number is 16-20 for large-caps. You get to see companies early. Also, these companies are the source of emerging innovation.

There’s a creative destruction dilemma for innovation companies. Small companies innovate and then get protective over time, as they grow big. Also, the law of large numbers means it’s difficult for companies to sustain their growth percentage over time.

TheStreet: Do you see small-cap growth stocks as an essential part of diversified portfolios?

Wong: Absolutely. Along with international, small-cap is one of the most neglected asset classes. One quarter of investors don’t view small-caps as an asset. Historically there has been a small-cap premium.

We haven’t seen that more recently. So there’s a prospect for mean reversion. There’s merit to both growth and value small-cap stocks.

TheStreet: What are the most attractive industries for small-cap growth stocks now?

Wong: One is healthcare. We gravitate toward medical devices: picks and shovels. They haven’t participated in the stock rally this year.

That’s because of concern about GLP-1 drugs for diabetes and weight loss. The idea is the drugs may lead to less medical procedures. But it will be many years before these drugs have an impact.

Medical devices have less binary risk than biotechnology, where drugs either work or they don’t. Devices are a profitable business.

Another strong industry is technology. There’s a lot of hype around artificial intelligence, but a lot of that hasn’t filtered down to small-caps. Big companies like Nvidia and Microsoft are the focus, and for good reason.

But I think emerging companies will be wave two for this. Vertical software companies — ones that serve only one area, such as healthcare or financial services — will be long-term winners. In AI, those who own the data are winners.

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

1. Axon Enterprise

(AXON) - Get Free Report They make non-lethal tasers and body cameras, and they’re increasing their presence in software. The data from body cameras can be sent to a police department via the software. They have stitched a whole ecosystem together with a positive network effect.

They have established a presence with law enforcement agencies, where they are deeply embedded. They’re getting recurring subscription revenue. They are expanding their customer base beyond the police force to customs and border patrols, jails, the FBI and overseas. The company is still very early in market penetration.

2. DoubleVerify 

(DV) - Get Free Report It provides ad verification software to ensure that digital ads are fraud free and delivered to real people. It’s a way for big advertisers to protect their brands.

DoubleVerify has 100% retention of their top 75 customers. Their customers have been with them at least seven years on average.

The digital ad market is forecast to grow 12% annualized through 2025, and DoubleVerify is growing 20%. Social media, such as TikTok, represent ripe areas for growth.

3. Shockwave Medical

(SWAV) - Get Free Report It makes medical devices using soundwaves to break apart plaque, particularly in coronary veins. It’s very innovative technology, less invasive than standard care.

This is an area where competition from GLP-1 drugs could have a negative impact. But that’s very far off. In the meantime, ShockWave’s products have only 20% penetration in their core market, [giving them room to grow].

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