Artificial intelligence (AI) is rapidly reshaping the world today. New AI tools are improving productivity, catalyzing innovation, and expanding business possibilities. As with past technology cycles, AI existed well before it went mainstream with the public release of OpenAI’s ChatGPT in late 2022. Even so, investors are buying into broad-based revolutionary promises of AI technology. While we see AI as one of the most significant technological shifts of our time, we think enthusiasm has pushed many smaller cap AI stocks ahead of their fundamentals.
While large cap companies like NVIDIA and Microsoft are most directly exposed to AI, the recent impact on equity returns of smaller cap companies has been notable. A wave of AI excitement has driven significant buying and valuation multiple expansion for smaller cap stocks in AI, quantum computing, and related technologies — despite unproven business models and a highly competitive corporate landscape of larger cap peers.
History rhymes in periods of exciting technological change, and we suspect the current AI revolution is no different. Recall that 1990s start-ups Google and Amazon prevailed through the “Dot Com” bust, transitioning from hope stories to fundamental successes. However, these two companies were among the few exceptions that survived. It is worth noting that over 90% of technology businesses incepted in the 1990s and 2000s have since failed.1 While new corporate champions can and do emerge from these periods of change, history has shown us time and again that investors misprice risk in the pursuit of high return opportunities.
The current smaller cap US equity market is led by a small group of prospectively high growth AI companies. These businesses exhibit exciting innovation potential, operate in large addressable markets, and are well funded. However, top-line growth does not always translate to robust profitability nor adequate returns on invested capital. While investors’ elevated risk-seeking behavior and fear-of-missing-out (“FOMO”) have benefitted these smaller cap technology companies, excitement is outpacing fundamentals like sales and profits. Even so, investors have been receptive to the issuance of new shares and debt instruments in capital markets, provided the mandate is funding growth to compete more effectively at scale with large, well-funded AI incumbents like Google and Microsoft. But for nascent smaller cap companies, high capital outlays and operating spending in the near term is a risk to balance sheet durability and corporate sustainability. We thus expect to see most smaller cap AI competitors and hopefuls produce negative operating margins, operate at high cash flow burn rates, and offer poor returns on invested capital that are likely well below their cost of capital, and thus not economically viable over the long term.
Quantum computing stocks are illustrative of the lofty investor expectations prevalent in the small cap market. Three smaller cap quantum computing stocks each appreciated by more than 2,000% last year.2 Meanwhile, the Russell 2000® Index appreciated about 11% in the same period. This outcome reflects a behavioral bias called “prospect theory,” where there is a small probability of a very large payoff. Analyst forecasts for the three companies suggest that combined revenue will be $33 million dollars in 2025. As of December 2025, the combined market capitalization of this group of smaller cap companies is $22 billion, implying a 666x price-to-sales valuation. For perspective, the Russell 2000® Index has traded in a range between one to three times price-to-sales in the past twenty years. There is no historical precedent for valuation multiples sustaining such lofty levels, suggesting a high probability that valuation and small cap AI stock performance will moderate as fundamentals fail to match heightened investor expectations.
At Boston Trust Walden, we believe we are positioned to mitigate the aforementioned biases through our commitment to quality as an investment style and our resolute focus on the long term. We seek to invest client assets in companies that we view to be fundamentally strong, as evidenced by their attractive margins and returns on capital. Many small cap companies we invest in are spending on AI (albeit with less investor fanfare than larger cap companies), and not just within the IT sector. The spending is often modest compared to total operating or capital expenditures, and the results are starting to become measurable in revenue, margins, and/or returns. Unlike their risk-seeking, high growth peers, these companies have the advantage of being able to reinvest in their businesses to test and integrate new technology, drive future growth, and improve competitive positioning, while remaining profitable and stable.
As one example of a company with strong fundamentals that is investing in AI, Williams-Sonoma launched an AI-based image recognition tool in July 2017 and acquired an AI-native virtual staging start-up a few months later.3 These investments benefitted existing profitable programs and expanded the company’s marketing capabilities, allowing the company to cut costs and enhance profitability. Since 2017, Williams-Sonoma’s E-commerce sales and corporate net margins have both doubled. While we do not wholly attribute the company’s success to AI, its highly cash generative business enabled thoughtful M&A and innovation that complement its legacy business model.
The current wave of AI innovation presents both risks and opportunities for investors and companies alike. As with previous technological disruptions, market enthusiasm can outpace underlying fundamentals, which is reflected in elevated current AI stock valuations. While a select group of small cap companies may emerge as long-term winners, history suggests that investors tend to overestimate their ability to identify those stocks early. For example, Yahoo famously passed on acquiring Google in 1998 for just $1 million — a reminder of how difficult it can be to separate structural winners from temporary beneficiaries. Over time, we expect valuations and expectations surrounding smaller cap AI stocks to converge with economic realities such as sustainable returns on investment. Through our consistent investment philosophy, we remain focused on high quality companies and we believe that such a normalization will refocus investor attention on companies with strong fundamentals and the ability to create long-term shareholder value.