- Small and mid-cap (SMID) tech companies have outperformed mega-cap peers in recent weeks.
- Investors should ride the trend and avoid Big Tech, a team of UBS strategists said in a recent note.
- Smaller companies have more attractive valuations and face less regulatory pressure.
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Stocks of technology giants have lagged their small and mid-cap (SMID) peers in recent sessions on the back of strong earnings results and comparatively attractive valuations.
A team of UBS strategists led by Mark Haefele, the firm’s CIO of global wealth management, said in a recent note that instead of taking profits in the smaller names and shifting back to large-cap tech, investors should ride the wave of recent outperformance.
Haefele recommends reducing exposure to large-cap tech stocks and diversifying with SMIDs, which are bound for faster earnings growth that isn’t priced in yet. Smaller tech companies should hit 25% earnings growth this year compared to 20% for their larger counterparts, the note read.
The tech sector got rocked earlier this year as bond yields crept up and investors took exception to higher inflation, which compresses earnings multiples and makes future cash flows less valuable. The Technology Select Sector SPDR Fund (XLK) sold off 9.2% from February 12 to March 8 in the midst of inflation fears, but has since rebounded and is up 11.3% this year. The gains, however, haven’t been evenly distributed.
SMIDs trade at a relative discount with 12-month price-to-earnings ratios in the low-to-mid 20s, as opposed to the mid-to-high 20s of mega-cap tech stocks, the strategists noted. Since the near-correction in mid-February, SMID valuations have slipped 10% to 15%, while those of mega-cap tech companies are down 0% to 5%.
Large-cap tech companies like Alphabet, Amazon, Apple, and Facebook face regulatory pressure in the US, Europe, and China, and must grapple with the prospect of higher taxes as political pressure from both sides of the aisle has escalated.
US lawmakers are voting on five bills this week that aim to break up and weaken tech giants following a 16 month federal investigation into practices and policies that critics call anti-competitive. Across the globe, Chinese e-commerce giant Alibaba was forced to eat a record $2.8 billion antitrust fine that led to its first-ever quarterly loss in Q1 2021, the team noted.
SMID tech companies don’t have these headwinds, the strategists said, arguing that smaller firms could be beneficiaries of a more even playing field. Instead, innovation will be lauded by hopeful challengers to mega-cap tech giants.
The team also noted that while larger firms are hamstrung by an inability to close future mergers and acquisitions without drawing the ire of regulators, modestly sized tech players have more to gain by joining forces. Such moves would introduce more formidable foes to mega-cap giants.
“With valuations of smaller tech firms still looking attractive overall, we see potential for this segment to benefit from takeovers by larger peers,” the note read. “By contrast, mergers and acquisitions in the mega-cap part of the market — which are generally less common — look even less likely than usual due to demanding valuations and regulatory pressures.”
Smaller firms are capitalizing on strong demand in software, digital advertising, and other areas of the tech supply chain. According to UBS, attractive opportunities can be found in themes like 5G wireless technology, financial technology (fintech), health tech, and green tech.