The rally is starting to broaden from mega caps. Here’s where smaller tech stocks can benefit
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Those expecting stocks to go higher in the coming months in anticipation of the Federal Reserve cutting rates may want to take positions in a familiar sector: tech. But specifically, smaller tech stocks. The thinking goes that some small- and mid-cap growth names — which have come under pressure from concerns of a recession — will benefit from the broadening out of participation from the mega-cap tech stocks, as well as a boost from artificial intelligence. For example, the SPDR S & P Software & Services ETF (XSW), an equal-weighted index of tech names, is starting to show signs of breaking higher after a year-long bottoming pattern, according to Ari Wald, head of technical analysis at Oppenheimer. As of Monday’s close, it’s up more than 30% this year at $141.83, close to its 2021 highs when it traded around $165. “We like the sector because it goes beyond the Magnificent Seven,” said Wald, who specified he likes large-cap names for their leadership and mid-cap names for their rotation potential. “You got a lot of these mid-cap growth stocks, mid-cap tech stocks, that are just starting to get going and reverse their 2021 to 2022 decline.” Specifically, he said he would buy AI growth beneficiaries such as Cloudflare and Twilio , which are up 72% and 46% this year, respectively. He also said he would buy the pullback in Tyler Technologies and MongoDB, which are down more than 1% and 5%, respectively, this month. Shopify and Roku are two other stocks that capture the mid-cap growth theme, he said. “A lot of these stocks are really just starting to break higher from yearlong basins,” said Wald, adding that they are not as overextended as large-cap names, and not so beaten up as some pandemic beneficiaries. “I think there’s a nice in-between there, and I think that’s the attractive balance that investors should be looking for.” Bokeh Capital Partners’ Kim Forrest favors optical materials maker Coherent , which has a roughly $6 billion market cap. In 2022, it was acquired by laser maker II-VI , which then adopted the name. She expects Coherent will benefit from generative AI in several ways, including tapping into the capacity required by telecommunications companies to keep up with the eventual demand. Separately, she thinks the company, which makes Lidar, a remote sensing method using light detection and ranging, has a role in the future of autonomous vehicles and robots. Smaller-cap tech stocks are often considered more risky than their larger-cap peers, as they’re expected to underperform in a downturn. Many market participants worry that the recent year-end rally, and some optimistic forecasts for 2024, may not be accounting for the effect that a long and aggressive series of rate hikes can have on the economy. “If people are anticipating a recession, it’s really hard for them to get out of the ‘don’t own a small company’ mindset. And I don’t think you can overcome that,” Forrest said. “There’s always going to be a group of investors that are going to shy away. And what you have to do, if you’re not one of them, is laugh all the way to the bank if you have the stomach, and you’ve selected the right company.” “Because, in time, what’s going to attract investors is the growth of the company,” Forrest continued. Forrest advised traders to stick to smaller-cap companies that aren’t overleveraged, with strong balance sheets and management teams. She said she wouldn’t choose companies with valuations below $1 billion, as she expects they’re too illiquid for traders, but she said small- and mid-cap names with valuations greater than that can offer investors the sweet spot: more liquidity than their small-cap peers, and more potential upside than large caps. “Go for high quality companies in every case,” Forrest said. “Companies that look like they can grow, like their products will be in demand in the next five to seven years — even though you may or may not have that time horizon.” Elsewhere, CFRA’s Sam Stovall said he remains positive on both large- and small-cap tech stocks, saying this year’s winners are likely to continue to outperform going forward. While laggards one year may be winners the next, the strategist said this is not typically so in the year following an up market. “If the market was down, then you want to buy last year’s losers … because investors move from first to worst. Yet, if the market was up, then you traditionally want to let your winners ride,” Stovall said. “They’re going up for a reason. And you don’t want to bail out of that too soon.”
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