Small Caps' Brewing Earnings Cycle Fueled by AI Infrastructure and Domestic Manufacturing

In a market dominated by mega-cap tech, the overlooked small-cap equity space may be staging a quiet comeback. This conversation with Greg Tuorto of Goldman Sachs Asset Management reveals that beneath the surface of recent underperformance, a powerful earnings cycle is brewing, fueled by cheaper valuations, a more active M&A landscape, and the subtle return of investor optimism--or "animal spirits." The hidden consequence? Companies that patiently invest in this segment now could unlock significant, long-term alpha. Investors who understand these underlying dynamics gain an edge by recognizing opportunities others are missing, particularly in sectors poised to benefit from resurgent domestic manufacturing and the build-out of AI infrastructure, even if the direct AI software plays remain elusive.

The Unseen Engine: Small Caps' Earnings Power

The prevailing narrative in equity markets has been dominated by the colossal growth of mega-cap tech. Yet, Greg Tuorto points to a less heralded, but potentially more potent, shift: a burgeoning earnings cycle within small-cap equities. After years of headwinds, particularly from rising interest rates, the landscape is changing. Tuorto highlights that small caps are not only cheaper than their large-cap counterparts--trading at a 25-30% discount--but are also poised for a more powerful earnings expansion. This isn't just about a cyclical upturn; it's about the fundamental characteristics of smaller companies. Their agility allows them to capitalize on emerging trends and M&A activity more effectively, creating a dynamic that can lead to substantial returns.

"We think it'll be a lot more powerful than the large cap earnings cycle. We also think they're a lot cheaper, about 25-30% cheaper than large caps."

The implication here is that while many investors remain fixated on the giants, a significant portion of the market is quietly building momentum. This creates a delayed payoff for those who recognize the underlying strength. The conventional wisdom might suggest sticking with the known winners, but Tuorto's analysis suggests that the real advantage lies in identifying where the next wave of growth will originate. This requires looking beyond the headlines and understanding the structural advantages small caps possess, such as optionality in the IPO market and the tailwinds from increased M&A activity.

The AI Infrastructure Play: Beyond the Hype

The AI revolution is often discussed in terms of software and direct AI applications. However, Tuorto offers a crucial systems-level perspective: the "picks and shovels" of AI infrastructure are where significant, durable opportunities lie for small caps. While the direct AI software companies might be caught in a hype cycle or facing near-term headwinds, the companies building the foundational elements--semiconductors, semiconductor capital equipment, and optical connectivity for data centers--are experiencing a resurgence. This is a critical insight because it decouples the AI opportunity from the direct software players, opening up avenues for investment in companies that are essential enablers.

The downstream effect of this infrastructure build-out is profound. Memory, for instance, is becoming a more significant cost driver for advanced AI models, directly impacting the economics of products like next-generation iPhones. Companies involved in memory production or the equipment to manufacture it are thus beneficiaries of this trend, even if they aren't developing AI algorithms themselves. This is where patience pays off; the infrastructure build-out is a longer-duration play than the often-fickle software hype. Investors who understand this distinction can position themselves for sustained gains, avoiding the volatility associated with direct AI plays.

"And I think that if you look at semiconductors, semiconductor cap equipment, which was nowhere two years ago and now is a leading sector in the market, and some of this optical connectivity that needs to connect these data centers together, there's a lot of opportunities there, a lot of ways to play it, a lot of different flavors of things to invest in."

The failure of conventional wisdom here is evident: many investors might dismiss small caps as being too far removed from the cutting edge of AI. However, by focusing on the essential components and infrastructure, Tuorto illustrates how small companies are crucial to the AI ecosystem's expansion. This requires a deeper understanding of the value chain, recognizing that essential support roles can generate significant returns over time, creating a competitive advantage for those who see this structural shift.

Domestic Manufacturing Resurgence: A Secular Tailwind

Tuorto's analysis strongly links the small-cap resurgence to a broader theme of domestic manufacturing revival. This isn't just a cyclical trend; it appears to be a secular shift, driven by policy and evolving global dynamics. He identifies key sectors poised to benefit, including defense and certain areas of biotechnology. In defense, innovation is not limited to drones but extends to the critical components and connectivity required for advanced military systems. This "built here" innovation is a significant driver for smaller, specialized companies.

The implication is that companies focused on domestic production and innovation are well-positioned to capture growth from government spending and strategic industrial policy. This contrasts with a globalized approach where manufacturing might have been offshored. The downstream effect of this shift is a more resilient domestic industrial base and a fertile ground for small-cap growth. Furthermore, the resurgence in biotech, following a period of dormancy, is being fueled by M&A activity and experienced management teams looking to exploit underfollowed areas within the US market. This creates a compounding effect: domestic focus drives innovation, which attracts investment and M&A, further strengthening the small-cap ecosystem.

"I think another area is on the defense side. We've had a lot of innovative companies go public, especially even recently on the defense side, and it's not all drones. Some of it's just the components that you need to kind of power these things, connect that drone that's flying around back to a ground station so you can get the data."

The advantage for investors here lies in recognizing that these aren't just isolated trends but interconnected elements of a larger economic restructuring. By investing in companies that are integral to this domestic manufacturing and innovation push, investors can benefit from a trend that is likely to persist for years, creating a durable competitive moat. The conventional approach might overlook these themes, focusing instead on global supply chains, but Tuorto's perspective highlights the strategic importance of understanding the domestic industrial landscape.

Navigating the Rate Environment and Financial Conditions

While the prospect of rate cuts is often seen as a catalyst for small caps, Tuorto offers a nuanced view of the current rate environment. He notes that while financial conditions are generally easy and credit spreads are stable, the banking sector, particularly smaller banks, still faces challenges in deposit gathering. This means rates may not be low enough to provide significant differentiation for them. Consequently, his team has a limited exposure to the banking sector itself.

However, he points to other parts of the financial chain, such as payments and insurance, where the rate environment is becoming less of a headwind and can even be a marginal driver of growth. The ideal scenario, from an investment perspective, would be a clear path for rate cuts, but Tuorto acknowledges that this may not materialize in the near term. The key takeaway is that while rates are a factor, the overall financial conditions are supportive, with no major "accidents" in private credit markets. This stability, even without immediate rate cuts, creates a more predictable environment for investment.

The systems thinking here involves understanding how different parts of the financial system react to interest rate movements. The immediate impact on banks is different from the impact on payment processors or insurers. By avoiding a blanket view on rates, Tuorto's approach allows for more targeted investments where the rate environment is either neutral or beneficial. This strategic positioning, anticipating the system's response rather than reacting to headlines, provides a distinct advantage.

Key Action Items

• Immediate Action (Next Quarter): Increase allocation to small-cap equities, focusing on companies with strong earnings potential and attractive valuations, particularly those in semiconductor, semiconductor capital equipment, and optical connectivity sectors.
• Immediate Action (Next Quarter): Research and identify small-cap companies involved in domestic manufacturing, especially within the defense sector, that are developing critical components and innovative technologies.
• Immediate Action (Next Quarter): Explore opportunities in biotech small caps that have shown recent M&A activity or are led by experienced management teams with a history of success.
• Longer-Term Investment (6-12 months): Begin to build positions in companies that provide essential infrastructure for AI, recognizing the "picks and shovels" approach as a durable strategy.
• Longer-Term Investment (12-18 months): Monitor the consumer spending data closely; if it continues to show resilience, consider increasing exposure to consumer-focused small-cap names.
• Strategic Consideration: Understand that investing in small caps may require patience, as the full benefits of the current earnings cycle and M&A activity may take time to materialize, creating advantage for those who can wait.
• Risk Management: Maintain awareness of the banking sector's sensitivity to interest rates and adjust exposure accordingly, favoring other financial sub-sectors where conditions are more favorable.