With AI valuations stretched, five small caps to look at into the year-end

By the end of this year, interest in small caps is picking up as investors confront an overheated tech sector and increasingly concentrated, outstripping growth by a handful of AI stocks. According to Alyona Nikolaeva, portfolio manager at asset manager Astero Falcon, the more attractive opportunities now lie in small caps, where fundamentals remain stable, and valuations within reason.

The U.S. economy enters December with mixed impulses. The Fed has already cut rates twice in the autumn, by 25 basis points each time, and FedWatch now shows traders assigning a high probability to another cut at the December 10 meeting. Historically, periods of monetary easing favor small caps – their sensitivity to funding costs is higher, credit transmission is faster, and the effect on profitability is more pronounced.

Trump's trade policy has strengthened the contrast. Small caps that rely on domestic demand gain from local scalability and are insulated from disruptions in global trade. Meanwhile, the AI-related capex surge has pushed a narrow group of large names to historic highs, concentrating gains and leaving most small caps at modest valuations. The valuation gap relative to large caps is now near a record 30%.

The small-cap lag that began in 2021 accelerated during 2023-2024 as the AI boom peaked. Yet BofA argues that the downtrend in relative earnings has ended. Earnings per share reversed in the second quarter of 2025 and strengthened in the third quarter. For 2026 BofA projects 19% EPS growth for small caps versus 13% for large caps. For private investors, the more effective approach is broad exposure, such as ETFs on the Russell 2000, rather than picking individual stocks.

The case for small caps is particularly strong in the defense sector. Geopolitical tensions, amplified by new technologies, are reshaping defense budgets. The renamed U.S. Department of War for the first time separated drones and counter-drone systems into a distinct category going into 2026. NATO has raised its spending commitment to 5% of GDP across two components, a shift that implies multiyear increases in demand for specialized contractors. Defense businesses tend to be resilient: they are anchored by government contracts, stable across economic cycles, and naturally inflation-proof.

Among the standout companies in this respect are AeroVironment and Kratos Defense & Security Solutions, although several lesser-known smaller players also have considerable potential.

Red Cat Holdings (RCAT)

Red Cat Holdings, a drone developer with a market capitalization of about $900 million, designs tactical drones for the U.S. Army and other government agencies. Its flagship Teal 2 system is built without Chinese components – a strategic advantage in a market reshaped by federal restrictions on Chinese-made drones. The resulting domestic-supply mandate has created a protected niche with only a few credible competitors.

Red Cat won a key U.S. Army program, the so-called Short Range Reconnaissance (SRR) Tranche 2, valued at $200 million over the next two years. The company is expanding into maritime drones and accelerating its international footprint. Third-quarter 2025 revenue surged 200% year over year to a record $9.6 million.

Red Cat’s successful entry into the federal contracting cycle gives it meaningful operating leverage: with a market capitalization of only a few hundred million dollars, even a modest expansion of government work can materially shift its valuation. After the company lowered its 2025 outlook due to the prolonged shutdown, the stock is trading at a sizable discount to recent highs. The consensus rating is “buy.”

Perimeter Solutions (PRM)

Perimeter Solutions, with a capitalization of about $4.1 billion, is one of the leading global producers of aerial and ground-based fire retardants. Rising climate risk has turned wildfire management into a structural growth trend. In 2024, the U.S. recorded a 14.7% increase in wildfires and a 231.3% surge in acres burned versus 2023. The company works with the U.S. Forest Service, CAL FIRE, and multiple international agencies.

Perimeter Solutions benefits from significant barriers to entry. Environmental certification takes years, and the production of retardant materials requires capital-intensive infrastructure that is difficult to replicate. The company is expanding in Australia, the Mediterranean, and Canada. The stock often weakens during rainy seasons, creating opportunities to invest in a business with long-term demand drivers and a competitive moat that is nearly impossible to challenge. The consensus rating is “buy.”

Climb Global Solutions (CLMB)

Climb Global Solutions, valued at $469 million, distributes enterprise IT solutions and provides vendors such as AWS, Microsoft, and Cisco with access to enterprise customers, adding engineering expertise and support. Climb is an unusual beneficiary of the AI cycle. Regardless of the success of individual AI projects, companies continue to invest in cloud infrastructure, networking, and cybersecurity, all of which support Climb’s business.

Third-quarter 2025 revenue grew 35% year over year to $161.3 million, with double-digit organic expansion. The acquisition of Douglas Stewart Software strengthens its education software business and adds scale. With a market capitalization under $500 million, Climb remains a potential takeover target, as large IT distributors continue to look for specialized, higher-margin niches. It has already showed that it can scale the business without major costs. The consensus rating is “buy.”

Guardian Pharmacy Services (GRDN)

Guardian Pharmacy Services operates in the pharmacy services segment of long-term care and runs 53 centers across 38 U.S. states. The business model is naturally defensive: long-term care facilities purchase medications regardless of economic conditions, giving the company stability uncommon within small caps. A high proportion of recurring revenue and long-term contracts creates predictable cash flow.

The company continues to expand its footprint through acquisitions and new sites. Third-quarter 2025 revenue rose 20% year over year to $377.4 million. Guardian raised its full-year revenue guidance to $1.43-1.45 billion and expects adjusted EBITDA of $104 million–$106 million. The combination of predictable cash flow and scalable growth makes the company a potential private-equity target. The consensus rating is “buy.”

Astronics Corporation (ATRO)

Astronics Corporation, with a capitalization of about $1.9 billion, manufactures high-tech electrical and electronic systems for the civil aviation and defense sectors. The company’s Aerospace division supplies power systems, avionics, lighting, and cabin equipment, while the Test Systems division develops automated inspection and certification systems. Customers include Boeing, Airbus, major airlines, and defense contractors, positioning Astronics as a core supplier within U.S. and European aviation infrastructure.

Third-quarter 2025 revenue increased 3.8% year over year to $211.4 million. The company expects fourth-quarter revenue of $225-235 million. Growth is supported by the rising electronics content in modern aircraft. New airframes require more power, integrated avionics, and connected systems, increasing Astronics’ share of components per aircraft. The company’s mixed business structure – roughly 60% civil aviation and 40% defense – mitigates cyclicality and strengthens its investor appeal. It also remains relatively unknown, which reduces the risk of inflated expectations. The consensus rating is “buy.”

This material does not constitute investment advice.