Why It’s Time for Investors to Branch out Into Smaller Tech Stocks

·5 min read

Move over, Facebook, Apple and Amazon. It’s time for smaller tech shares to shine.

Investment bank UBS envisions big things from small and mid-sized tech company stocks. The firm expects these companies to outperform mega-tech companies in the near term, Mark Haefele, Chief Investment Officer at the firm, wrote in June.

Small and mid-sized tech firms have gained close to 10% in the past month, versus just under 5% for global mega caps, he wrote at the time. FAANG stocks — Facebook, Amazon, Apple, Netflix and Google — have had a great few years. The tech giants led the stock market recovery after the pandemic-induced crash, each up at least near 30% in 2020 while the S&P 500 gained just 16%. But with potential regulation down the pipeline and the market continuing to recover from the pandemic, experts say it’s a good time to trade some of the big names for ones you may not know.

Why FAANG stocks face risk

One year ago, John Freeman, vice president of equity research at investment research firm CFRA had a “buy” recommendation for Facebook and a “strong buy” recommendation for Alphabet (Google’s parent company). He just downgraded both.

Tech giants are facing a lot of potential regulatory risk — and it isn’t showing signs of slowing down, he says. Big tech companies around the world are facing scrutiny from their governments for taxation and antitrust practices. In June, all eyes were on Facebook as it went up against complaints from the the Federal Trade Commission and state attorneys general that the company had a monopoly on social media. While those complaints were thrown out, regulators seem hard set on breaking up Silicon Valley’s giants. Smaller tech companies likely don’t have to worry about similar regulation, since much of the scrutiny is about leveling the playing field, Haefele wrote in the UBS note.

Haefele also pointed out that smaller and mid-sized tech firms look like they might soon see faster earnings growth. UBS is expecting earnings growth of around 25% this year for the smaller tech firms, versus around 20% for mega-tech.

Plus, merger and acquisition activity tends to pick up after a financial crisis. Smaller tech companies have the potential to benefit, Haefele wrote.

The Federal Reserve’s upcoming decisions could also change the landscape for tech giants. The agency has hinted that it may raise interest rates sooner than originally anticipated, which will put pressure on big tech companies, says Sandy Villere, portfolio manager of the Villere Balanced Fund based in New Orleans, Louisiana. That’s because investors value technology stocks based on projections of future earnings, but inflation could erode them. The end result is lower future earnings, which lowers the value of the current stock price. Small-cap stocks, however, tend to do well in a rising rate environment since that means the economy is heating up, and small companies outperform during an economic recovery, Villere adds.

How to find the right small and mid-sized tech stocks

So if it’s time to take some of the large names off the table, which tech stocks should you turn to?

Go for companies that dominate a particular niche, Villere says. For example, he likes ON Semiconductor, a semiconductors supplier company, which he says is a play on the advent of 5G in power and data management.

As for Freeman, he likes stocks of companies that are helping other businesses adapt to the tech-first, pre-pandemic world. These include New Relic, software that analyzes software performance, Nice Systems, which automates customer service using machine learning and Commvault, which provides back and recovery software.

“I’ve never been more bullish on the software sector,” Freeman says.

Of course, finding these stocks is harder said than done — and professionals on Wall Street spend tons of time looking for the next Silicon Valley darling to explode. That’s why Hagen Pruemm, financial advisor and owner of SIS Financial Group in Hoffman Estates, Illinois, says exchange-traded funds (ETFs) may be the way to go. Sure, there will be some losers in the bunch but there will also, hopefully, be some winners.

“Picking the right winners of individual securities is going to be tough,” Pruemm says. “You’re going to get a much broader diversification being allocated over a variety of ETFs that can give you the same exposure to small-cap or mid-cap or growth or value stocks.”

The Invesco Dynamic Software ETF and SPDR S&P Semiconductor ETF are both gold-rated by Morningstar, meaning they’re top recommendations from the investment and research firm within their categories, according to Morningstar data.

Sector exposure aside, keep in mind that you should always have some small-cap stocks — or a total-market fund — to ensure you have exposure to companies that may do well when large caps stumble. Only owning the S&P 500 means you’re putting all your eggs in one basket.

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