The AI investment landscape is evolving beyond Big Tech giants and utilities, with small-cap software companies emerging as the next wave of AI beneficiaries. Bryan Wong, portfolio manager of the Osterweis Opportunity Fund (OSTGX), has successfully capitalized on this trend, delivering a 22% return in 2024 compared to the Russell 2000’s 15% return.
Wong’s San Francisco-based fund focuses on overlooked opportunities in companies using AI to grow their margins, particularly in the vertical software space. Unlike horizontal software providers like Salesforce or Microsoft that serve multiple industries, vertical software companies specialize in specific markets, creating competitive advantages through focused distribution, proprietary data, and stronger customer relationships.
As Wall Street shifts toward “Phase 3” AI stocks—companies directly using AI to enhance revenues—Wong has identified three key holdings that exemplify this strategy:
Guidewire Software (GWRE) - Market Cap: $14.4 billion The dominant player in property and casualty insurance software, serving major insurers like Geico, State Farm, and Allstate for mission-critical claims filing and processing systems.
Axon Enterprise (AXON) - Market Cap: $44.2 billion Originally founded on TASER technology, Axon has expanded into body cameras and cloud-based software for law enforcement. Their hardware products serve as data collection points, with body camera footage wirelessly uploaded, timestamped, and transcribed using AI capabilities.
Duolingo (DUOL) - Market Cap: $13.7 billion The gamified language-learning platform has outperformed expectations through AI-enhanced video lessons. Co-founder and CEO Luis von Ahn, a Carnegie Mellon professor who previously sold reCAPTCHA to Google in 2009, brings deep technical expertise to the company’s AI implementation.
Wong emphasizes that small-cap software companies are especially well-positioned for the next wave of AI investing. Their ability to develop specialized niches with sticky revenue streams, combined with more efficient sales and marketing focused on single verticals, gives them advantages over larger competitors spreading resources across hundreds of industries. Goldman Sachs and other major banks are now recommending this investment approach as the AI trade matures beyond infrastructure plays.
Key Quotes
If you’re a vertical-specific company, you own the distribution, you own the data, you have relationships with the customers. You can be more efficient on sales and marketing as well because you’re focused on one vertical.
Bryan Wong, portfolio manager of the Osterweis Opportunity Fund, explains why small-cap vertical software companies have competitive advantages in AI implementation compared to horizontal software giants like Salesforce that must spread resources across hundreds of industries.
Guidewire is the 800-pound gorilla of insurance property and casualty insurance. Companies like Geico, State Farm, and Allstate use Guidewire for their mission-critical claims filing and processing.
Wong describes Guidewire Software’s dominant market position in insurance technology, illustrating how vertical software companies can achieve market leadership in specific industries while leveraging AI to enhance their core offerings.
This is a stock that I think very few people were following and paying attention to, but it’s outperformed in video lessons.
Wong discusses Duolingo’s unexpected success, highlighting how overlooked small-cap companies using AI for product enhancement can deliver outsized returns that most investors miss by focusing only on Big Tech AI plays.
Our Take
Wong’s success reveals a fundamental truth about AI investing: the real money may not be in building AI, but in using it effectively. While Nvidia and hyperscalers captured Phase 1 and 2 of the AI boom, Phase 3 represents a democratization of AI value creation across industries.
The vertical software thesis is particularly compelling because these companies possess the two critical ingredients for AI success: proprietary domain-specific data and deep customer relationships. Unlike horizontal platforms that must be generalists, vertical software companies can fine-tune AI models on industry-specific datasets, creating defensible competitive advantages.
What’s notable is how quickly some of these “small-cap” picks have grown—Axon’s $44 billion market cap hardly qualifies as small anymore. This suggests we’re still early in identifying AI beneficiaries, and investors willing to look beyond obvious plays may find significant opportunities in overlooked sectors where AI can drive margin expansion and revenue growth.
Why This Matters
This story signals a critical shift in AI investment strategy from infrastructure providers like Nvidia to companies actively deploying AI to transform their business models. While most investors have gained AI exposure through the S&P 500’s Big Tech concentration, the maturation of AI technology is creating opportunities in overlooked segments of the market.
The 22% outperformance of Wong’s small-cap focused fund demonstrates that AI’s value creation is spreading beyond chip makers and cloud providers to end-users of the technology. This validates the “Phase 3” investment thesis that companies using AI to enhance revenues and margins represent the next frontier of AI investing.
For businesses and investors, this trend suggests that vertical software companies with domain expertise and proprietary data are better positioned to monetize AI than generalist platforms. The competitive advantages of focused distribution, customer intimacy, and efficient go-to-market strategies in specific industries create sustainable moats that AI can amplify. This shift has broader implications for how AI value will be captured across the economy, moving from technology providers to industry-specific applications.
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