The Hunt for ‘Desert Island’ Small-Cap Stocks

It’s been an uphill battle for most investors in small-company stocks for many years. The Vanguard Russell 2000 ETF VTWO has returned 9.11% a year on average over the past 10 years. Compare that with the blistering 14.77% for the SPDR S&P 500 ETF SPY amid enthusiasm for the Magnificent Seven and other fast-growing, large-company stocks. While small-cap stocks have outperformed large-company stocks over the last three months, it’s a deep hole for many strategies to climb out of.

But Andrew Beja, who has run small-cap portfolios for 40 years, sports a track record on Granahan Investment Management’s Small Cap Focused Growth Strategy that has left large-cap stocks in the dust. He and his team of nine hunt for what he calls “Desert Island” stocks. These are small companies that will turn into multi-billion-dollar enterprises. It’s been a highly profitable approach. The $1.33 billion, concentrated strategy is up 46.1% for the 12 months ended June 30, 9.6% annualized over five years, and 17.6% per year over the last decade.

The Granahan strategy isn’t available as a fund for US investors, and Beja primarily manages money for institutions, advisors, and high-net-worth individuals. However, there’s a UCITS for non-US investors. For those stateside, Beja shared with Morningstar what makes a company a Desert Island pick, what artificial intelligence could mean for small-cap stocks, and a few of his favorite names.

For more, keep reading the following, which is a condensed, edited version of our conversation.

Leslie Norton: Why are small-cap stocks beating big-caps now?

Drew Beja: There is some consensus building that interest rates might be heading lower, and that would be constructive for small caps. I’m not counting on that to happen for our secular growth, Desert Island-worthy companies to do well.

Norton: What would it take to see sustained outperformance?

Beja: A tailwind would start with interest rates going lower. Sentiment for a number of years has focused mainly on the narrow set of companies in the Magnificent Seven. So envision a world where the fruits of AI and lower rates combine to breathe air into the fire of small cap. I’m not predicting that. I’ve been doing this too long to think guessing when it’s time to be in small versus large is a sustainable way to invest. I’m trying to put up good numbers in most intermediate-to-long-term environments. Also, all else being equal, smaller companies are less efficiently priced than large caps. There are exciting growth companies that are typically mispriced.

Norton: Companies are going public much later, when they’re much bigger. What does this mean for small-cap investors?

Beja: For the last year and a half, the IPO window has been only slightly open. That’s my favorite kind of IPO market—high-quality companies, and not a lot of investors flooding into them. In the last four months, the window is opening. A ton of companies would like to come public. There will be demand from institutional investors, and now retail, which is a very important variable in the supply/demand equation. That demand will depend on how they do in the aftermarket.

Desert Island Stocks

Norton: Let’s hear more about these Desert Island companies.

Beja: These are secular growth companies taking a share of GDP. If you are on a desert island for three to seven years and then returned, you’d find these companies to be much much bigger.

Our method is akin to the net promoter score, which asks how likely you would be on a scale of 1 to 10 to recommend X. That allows you to compare Mercedes to Starbucks to the local ice cream chain. Hundreds of things go into a desert island company: big opportunities, moats, strong management with integrity, shareholder-friendliness, a good culture, strong financials. These are must-haves.

We also create expected return and risk/reward valuation scenarios for each stock. What’s the most likely scenario for earnings growth, and what are the upside and downside scenarios? We think through, debate, model. For each time frame, we have five scenarios. And from that, we get to a probability-weighted expected return. And from this expected return, we can compare Axon Enterprise AXON to Genius Sports GENI to First Watch Restaurant Group FWRG.

In small cap, it’s particularly important to be aware of your downside scenarios. So we’re also careful about portfolio construction, and diversifying by factors, and different kinds of growth drivers. We monitor 100-ish Desert Island-worthy companies. We can only own about 40 stocks. It’s like the Marines: The Few, the Proud.

Norton: How do you think through those downside scenarios?

Beja: We discuss negative scenarios for each stock. For example, we own Toast TOST, which you’ve probably used. It’s a complete platform for the front of the house for a small- to midsize restaurant. We’ll go through the “what if” exercise on Toast. What if we knew for certain that overall restaurant sales were going to slow and that the company was also going to fall short on Q3 new store additions? We’d then ask ourselves “How will investors value Toast if that happens? What would the company earn? What would be the likely multiple investors would put on those earnings? What would happen to the stock?” Then we assign a probability to that scenario. To build in a margin of safety, we have a rule that at least 25% of the probability must be assigned to the bad or really bad scenarios.

The Sweet Spot for Small Companies

Norton: For a small-cap fund, you own some very large companies.

Beja: Our average market value is skewed by a few larger-cap names. We bought Tesla TSLA at about $3 billion, sold it around $30 billion. We bought Shopify SHOP at $2 billion, sold it mid-$20 billion range. We’ve now stopped selling purely because of market cap. For example, we’ve owned Axon, formerly known as Taser, since it had a market cap of $300 million. It’s now around $50 billion. We’ve owned Toast and HubSpot HUBS since they were very small.

We typically buy companies in the $2 to $5 billion range. I don’t have a hard, fast rule because of my years of experience. We rarely buy a new name north of $10 billion. Although if I found the best Desert Island-worthy company at $11.5 billion, I’m gonna buy it all day. We’ve got a good hit rate at identifying the Teslas, the Shopifys of the world.

Why Small Caps Are Starting to Benefit From AI

Norton: Let’s talk about AI and small caps.

Beja. I ran money in the lead-up to the dot-com euphoria, the crash, and the aftermath. Most people believe AI will be hugely transformative but that we’ve yet to see anything close to how it will all play out. In the early phases of AI, it’s natural that investors gravitate to the hyperscalers and the Nvidias NVDA and suppliers to both of these, because it’s clear they’re early beneficiaries. The same was true with the Internet. And just as it started to broaden in the internet, it seems to be broadening now. That’s natural. It’s been two and a half years since ChatGPT4 was released, and it’s logical that investors look for real tangible customer value propositions they can sink their teeth into. Just about every company out there will have huge transformative impact from AI. We stay away from stocks that don’t have a moat and just had great momentum from AI.

Norton: What Desert Island stocks do you like?

Beja: Genius Sports is one of two dominant companies that supply data for sports betting. The other is Sportradar SRAD. Sports betting is two-thirds of Genius’ business. The other third is from a tech suite of offerings. Genius and Sportradar split the most important sports rights. For example, Genius has exclusive rights to official NFL data and to English Premier Football, or soccer, data. Sportradar has exclusive rights to NBA, and Major League Baseball, and a few others. Neither company has exclusive rights to third-tier events. The DraftKings, FanDuels, Fanatics, MGMs of the world need that data to offer hundreds of bets.

We’re early in the maturation of online sports betting in the US. It’s state-by-state-regulated. Many states have legalized it, but many big states have not. In Florida, only one Indian tribe has done it. It’s not legal in Texas or California.

Genius became profitable about a year and a half ago. They’re growing their top line 20%-23%, but profits and free cash flow are growing much faster.

The stock price is $13. Our expected return over the next 12 to 18 months is $22. That would be 20 times 2027 EBITDA [earnings before interest, taxes, depreciation and amortization]. It’s September 2025. By September 2026, most investors will likely be fully focused on 2027, which is a 12-ish-month time frame.

Norton: What’s your thesis for Archer Aviation ACHR?

Beja: Archer is one of two leaders in EVTOL, or electric vertical takeoff and landing. This is Jetsons-like transportation. Archer sells EVTOL aircraft that combine the vertical takeoff and landing of helicopters with the speed and efficiency of traditional planes. People think this is many years away and yet we are starting to see piloted flights today. We’re likely to see commercial flights in the next 12-15 months, probably first in the UAE, but shortly after that in the US. We value it like how we valued Tesla in 2012-13, when you had to go forward five to seven years to when the Model 3 would become mainstream and discount it back. I’m not suggesting Archer stock will do what Tesla did. But with Archer, you don’t even have to go out that far. Archer will likely start to generate positive EBITDA in 2027 and meaningful EBITDA in 2029. The main thesis is commercial, but Archer is also working closely with Anduril to adopt its EVTOL technology for defense applications. In commercial, they’re likely to be in three markets—New York, Chicago, and LA—by 2027. They’re official EVTOL company of the 2028 Olympics. If we see that kind of penetration, that can get them to EBITDA positive in 2027, and start to be meaningful in 2028.

Norton: What’s it worth?

Beja: They’re much further along than the consensus realizes. Looking at 2027, our most likely scenario is $22. The stock is $8.40. We have a much bigger investment in Genius Sports than Archer, because we care about downside risk. Archer has more upside potential over the next two to four years but almost more downside.

Norton: You mentioned restaurant stocks. What’s the thesis for Kura Sushi USA KRUS?

Beja: It’s low-end sushi. It’s a fun concept, with a highly automated conveyor belt both in front of the house and back of the house. Robots deliver your drinks. There are automated dishwashers. Kura in Japan has about 500 restaurants. They started the US operation from scratch 15 years ago. It has 78 stores. Kura Sushi Japan owns 35%. US Kura gets the benefit of all the research and development and learning that come with a 500-store chain. For example, there’s a loyalty plan they’ve tested in Japan that they’re rolling out now in the US.

A number of competitors in low-end sushi are all out of business. Kura could have well north of 1,000 stores someday. They’re growing revenue about 25% annually and enjoy high incremental margins that are enabling the bottom line to grow even faster. It has a strong management team, an open-ended opportunity, and a significant moat. In a world where AI will disrupt many companies, we believe Kura Sushi is not only safe but should benefit over the next few years as it has the scale to use AI in ways that its smaller competitors do not.