MW This investing strategy digs deeper to find hidden stocks riding the AI wave
By Philip van Doorn
There are plenty of ways to jump into the generative-AI hardware infrastructure expansion beyond the familiar chip makers and hyperscalers.
Microcap stocks have outperformed those of larger companies on an index level over the past year. And a tech-focused microcap strategy has done even better.
When discussing the stock market's performance, investors often look year-to-year at the indexes' total returns. But this is a good time to look at a 12-month chart through May:
The Russell Microcap index has outperformed broad-based indexes of small-caps and larger companies over the past year.
Investors have been focused on the generative-AI infrastructure build-out, through which stocks of large manufacturers of graphics processing units (especially Nvidia), other semiconductor manufacturers and now makers of computer memory chips and peripherals have gone into the stratosphere. But on a broad index basis, you can see that microcap stocks have outperformed small-caps and larger companies over the past year.
So microcaps are worth a look. And the Royce Micro-Cap Fund RYOTX outperformed the Russell Microcap Index with a 68.2% return for 12 months through May. Jim Stoeffel, who has been co-managing the fund for 10 years, discussed his investment strategy, naming several examples of microcap companies well-positioned to gain from the increasing adoption of AI.
Royce Investment Partners is a subsidiary of Franklin Templeton and is based in New York. The firm has $11.3 in total assets under management, including a combined $1.3 billion managed under its microcap strategy. This includes $371 million in the Royce Micro-Cap Fund and $798 million in the Royce Micro-Cap Trust RMT, a closed-end fund that trades on the New York Stock Exchange.
Defining the microcap space
The above chart shows performance for three Russell indexes and the S&P 500. The best way to understand how Russell divides stocks into company-size categories is to begin with the Russell 3000 index, which is designed to capture 98% of the combined market capitalization of common stocks listed in the U.S.
The Russell 1000 Index RUI is made up of the largest 1000 companies in the Russell 3000 Index RUA by market cap, when the indexes are reconstituted each June and December, typically on the last Friday of the month. The Russell 2000 index RUT is generally considered to be the benchmark for U.S. small-cap stocks. It is made up of the smallest 2000 companies in the Russell 3000.
The Russell Microcap Index comprises the smallest 1,000 companies in the Russell 3000, but can include additional stocks among those in the Russell 2000. The Russell 1000 Microcap index was made up of 1,280 stocks as of April 30, according to FTSE Russell.
Within the Russell 1000, the median for companies' market caps was $16.9 billion as of April 30. Within the Russell 2000, the median market cap was $1.1 billion, while the median was $287 million for the Russell Microcap Index.
Investors in funds tracking microcaps and small-caps make broader plays than they do with the large-cap indexes. The indexes are weighted by component companies' market capitalization. With no upper limits for the large-cap indexes, the State Street SPDR ETF Trust SPY, which tracks the S&P 500 by holding all of its stocks, is 8% weighted to Nvidia (NVDA), while the largest 10 companies make up 40.2% of the fund. The iShares Russell 1000 ETF IWB has a 36.3% weighting to its largest 10 companies.
FTSE Russell's indexes of smaller companies have market-cap limits, which means some stocks that have soared will be moved up when the indexes are reconstituted in June and December. Concentration at the top of these indexes will increase during bull markets before reconstitution. But they are still far less concentrated than the large-cap indexes. The Vanguard Russell 2000 ETF VTWO has a 6.6% weighting to its top 10 and the iShares Micro-Cap ETF IWC, which tracks the Russell Microcap Index, has a 13.8% weighting to its top 10 holdings.
According to Stoffel, the Royce Micro-Cap Fund typically invests in companies with market caps ranging from $500 million to $700 million, although the market caps can get much higher when the Royce team's selections pan out well.
Microcaps and AI
The Royce Micro-Cap Fund held 158 stocks as of April 30. Stoeffel described a "manual, intensive process" through which he and the fund's co-manager, Andrew Palen, use research from all of Royce's portfolio managers and analysts because the firm is entirely focused on small-cap and microcap stocks.
Stoeffel said the fund tends to be "overweight technology and industrials," when its industry concentration is compared with that of the Russell Microcap Index. The fund also tends to be underweight in banks and biotechnology, because the latter group is "not necessarily profitable," he said.
"If biotechs rip, we tend to underperform," he said. The fund's concentration has worked out well over the past year, as holdings in varying industries have benefited from the AI hardware build-out. These include Ultra Clean Holdings $(UCTT)$ and Ichor Holdings $(ICHR)$, both of which provide systems and subcomponents to Applied Materials $(AMAT)$ and Lam Research $(LRCX)$, which in turn make semiconductor manufacturing equipment used by the largest chip makers.
Ultra Clean's stock was up 342% for one year through May, sending its market cap up to $3.84 billion. With that type of performance, Stoeffel said he and Palen would typically "trim" a position, but he added that it was not unusual for the fund to hold stocks with market caps up to $6 billion if a stock had been performing well.
Five analysts working for brokerage or research firms polled by LSEG follow Ultra Clean. The consensus estimates from calendar 2026 through 2028 project a 24.1% compound annual growth rate (CAGR) for the company's revenue. This compares to weighted projected revenue CAGR from 2026 through 2028 of 8.1% for the S&P 500 and 21.6% for the S&P 500's information technology sector, according to LSEG. Meanwhile, Ultra Clean's forward price/earnings ratio, based on the consensus estimate for earnings per share over the next 12 months, is 25.3. This valuation compares with the weighted forward P/E of 21.1 for the S&P 500 and 24.2 for the S&P 500 IT sector. So one could argue that Ultra Clean's stock is not expensive, despite the run-up.
Through May, Ichor's stock was up 353% from a year earlier, while its market cap had increased to $2.49 billion. This stock is followed by seven analysts polled by LSEG. Its forward P/E is 36.1 and the projected sales CAGR from 2026 through 2028 is 10%.
Other holdings of companies Stoeffel said were benefiting from AI adoption include several energy-related plays:
-- NPK International NPKI makes and rents out recyclable composite matts used for power transmission as well as oil and natural gas exploration and production.
-- Mistras Group MG provides various inspection and testing services to energy producers, electric utilities, aerospace and defense equipment manufacturers and companies involved with civil engineering.
-- Riley Exploration Permian REPX is a natural gas producer. Stoeffel said his investment case for the stock included the need for increased power generation for data centers. "We love that space," he said.
Top holdings
These were the largest 10 holdings of the (out of 158) of the Royce Micro-Cap Fund as of April 30:
Stock % of Royce Micro-Cap Fund portfolio Lincoln Educational Services 1.7% Ultra Clean Holdings 1.5% 5N Plus 1.5% Ichor Holdings 1.4% Sprott 1.4% Ezcorp 1.4% Cohu 1.4% NWPX Infrastructure 1.3% Natural Gas Services Group 1.3% ADTRAN Holdings 1.3% Source: LSEG
Performance against peers
LSEG lists dozens of mutual funds as competitors to the Royce Small-Cap Fund's Investor share class and has calculated one-year returns and longer-term average annual returns through May, with dividends reinvested and excluding any sales charges.
The Royce Small-Cap Fund is benchmarked to the Russell Microcap Index. LSEG lists five competing funds that are benchmarked to the same index.
The following performance comparison begins with the Royce Small-Cap Fund, followed by the Royce Micro-Cap Trust and then iShares Micro-Cap ETF IWC, which is a passively managed exchange-traded fund designed to track the performance of the Russell Microcap Index.
The five competing funds follow, sorted by average annual returns for 10 years through May 31.
Asset Name 1-year return 3-year avg. return 5-year avg. return 10-year avg. return Net expense ratio
Royce Micro-Cap Fund; Investment 68.2% 27.4% 11.1% 13.7% 1.24%
Royce Micro-Cap Trust 69.1% 27.2% 10.7% 14.0% 1.39%
iShares Micro-Cap ETF 62.2% 24.3% 6.2% 11.7% 0.60%
Paradigm Micro-Cap Fund 46.8% 16.1% 6.3% 14.6% 1.27%
Wasatch Micro Cap Value Fund; Investor 27.4% 19.4% 4.5% 13.9% 1.68%
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June 04, 2026 09:07 ET (13:07 GMT)
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