Small-cap tech stocks tend to get overshadowed by their large-cap counterparts known as the FANGs.
But the FANGs—a tech quartet of Facebook (ticker: FB), Amazon.com (AMZN), Netflix (NFLX), and Alphabet (GOOGL)—don’t look nearly as appealing as the “mini-FANGs,” according to Jim Paulsen, chief investment strategist at Leuthold Group.
Paulsen, in a note published Monday, argues that small-cap tech looks like a bargain compared with large-cap peers. The S&P 600 Small-Cap Technology index trades at about half the valuation of the S&P 500 Technology index, he writes. That’s down from 0.9 times for small-cap tech in 2013, and it’s well below the 18% average premium for small-cap tech since 2003 (based on a composite valuation of price/earnings, price/book, and price/cash flow).
Profit estimates for small-cap tech are higher too. The S&P 600 tech index has a long-term growth estimate 43% higher than the S&P 500 tech index, Paulsen notes. Accordingly, “the mini-Fangs offer a significantly higher growth profile at a substantially lower valuation,” he writes.
Granted, the S&P 500 Information Technology index isn’t a great proxy for the FANGs anymore. Three of the four FANGs (Facebook, Netflix, and Google) were switched to a new sector, Communication Services, by S&P Dow Jones Indexes in September, 2018. Amazon was never a tech stock either, according to S&P. It’s long been categorized in the Consumer Discretionary sector.
The S&P 500 tech sector does include some heavyweights, though, including Microsoft (MSFT), Apple (AAPL), Intel (INTC), and Cisco Systems (CSCO), along with payments companies Visa (V), and Mastercard (MA). But the sector doesn’t offer nearly as much exposure to tech trends such as social media or e-commerce, which are more at home in the communication services and consumer discretionary sectors.
Investors might be skeptical of Paulsen’s argument because small-cap stocks overall have trailed large-caps for years. The Russell 2000 small-cap index has returned 12.5% this year, including dividends, versus a 19.6% total return for the S&P 500. Small-caps are also trailing large-caps over the last one-, three-, five-, and 10-year periods on an annualized basis.
So why tilt to small-caps now, and especially tech? Paulsen argues that if we get slightly better economic data, including a bump in inflation, small-caps should outperform, since they tend to do well when inflation is picking up. He also notes that small-cap tech volatility has spiked, relative to large-cap tech. That has often preceded a period of small-cap outperformance. Analyst price targets for small-cap tech also imply bigger gains, with small-caps expected to appreciate 11% more than large-cap tech peers.
Overall, Paulsen writes, the mini FANGs “are less popular, widely under owned, offer a substantial valuation upgrade, a faster long-term growth profile, and are not in the crosshairs of antitrust regulators.”
For exposure to the mini FANGs, consider an exchange-traded fund. Invesco S&P SmallCap Information Technology ETF (PSCT) tracks the performance of the S&P 600 Small Cap tech index. It’s up 24% this year. Its expense ratio is 0.29%.
And what exactly are the mini-FANGs? The top holdings of the ETF include SolarEdge Technologies (SEDG), Cabot Microelectronics (CCMP), Viavi Solutions (VIAV), Brooks Automation (BRKS), and Qualys (QLYS).