Mega-caps have led market growth this year, but changing rate expectations could make for an inflection point, says PM
Given the tech’s sector’s traditional place as a risk-on sector for institutional investors, it’s notable that seven tech companies are leading market growth. We are in a period of elevated interest rates, recessionary fears, and weakening investor sentiment, yet the Magnificent seven — Tesla, Amazon, Apple, Alphabet, Meta, Nvidia, and Microsoft — have grown while other parts of the tech sector have lagged.
Against the leadership of the magnificent seven, smaller and supposedly riskier tech companies haven’t experienced the same kind of growth. There is a chance, however, that this might change as investors digest earnings season in tech and an unexpectedly low CPI print in the United States.
“I think investors were shellshocked after the whole of 2022, and they flipped back to the playbook after a lot of excitement built around AI and said ‘what are we going to default into,’ and the big tech stocks were there,” says Nicholas Mersch, portfolio manager at Purpose Investments.
“There was a new conception amongst investors that saw large-cap tech as a pretty good defensive play and multiples started to expand pretty steeply…When you get to the acceleration part of this cycle, which I think we’re approaching right now, that’s when many of these mid-cap companies can show better performance.
“I don’t think we’re there yet, but it’s coming.”
Mersch explained that the flight to mega-cap tech as a defensive play this year was spurred, in part, by the significant and growing hype around artificial intelligence (AI). While that was widely reported this year and AI continues to grab headlines, he notes that many of the mega-cap tech companies have also treated 2022 and 2023 as ‘years of efficiency,’ cutting headcount and expenses to make themselves more profitable and shareholder friendly. In doing so, the names in the magnificent seven started to look more like value plays with a tech growth outlook.
The most recent round of tech earnings reports, especially from mega-caps, has been more mixed however and could signal a shift away from their dominance of market growth dynamics. Software companies had previously enjoyed long contracts with their clients, which now appear to be shortening. Mersch highlights that deals are being more heavily scrutinized and while growth rates are resuming at some of these companies, the AI sentiment rally this year has made valuations less attractive in the mega-cap space.
Mersch still believes that, compared to these mega-cap companies, investors in more mid-cap tech may still need to wait for performance to pick up. Those companies traded at extremely high multiples during the ‘everything rally’ of 2021 thanks, in part, to the ‘free money’ available during and immediately following the COVID-19 pandemic. Analysts argued that the growth figures for these companies were good enough that they could grow into their inflated valuations, but as rates hiked up during 2022 we saw those companies’ valuations crushed by a shift in investor sentiment. Now, however, we may be reaching an inflection point for mid-cap tech stocks.
In the wake of yesterday’s unexpectedly low US CPI print some of those companies have done better. As investors now begin to rule out the likelihood of another Fed hike this year Mersch says certain mega-cap tech stocks like Microsoft traded largely flat, while those higher-beta names jumped higher. Those companies haven’t seen much of a recovery from their 2022 losses, but if rates do ease up Mersch sees a run up in valuations as more and more likely.
While growth dynamics and fundamentals in the tech sector may be entering a period of change, Mersch thinks that the continued adoption and expansion of AI technology is worth paying close attention to. Advisors who are looking to capture more growth upside from tech stocks may want to keep looking at AI even as the initial hype subsides.
“It’s a buzzword, and everybody’s talking about AI but it really is one of these generational themes, and I think if you really pay attention to it you can start to pick winners in this space,” Mersch says. “In terms of investing in the entire stack of artificial intelligence there are four key areas: the physical components, the cloud technology, the infrastructure software, and the application software.”
Mersch cites Nvidia as a leader in semiconductors for the physical components but notes that a number of other raw materials and supply chain companies like ASML, LAM Research, and TSMC have exposure to that area. He believes Amazon, Google, and Microsoft are leading the charge on cloud technology. Infrastructure software means data storage and training models, companies like Snowflake, MongoDB, and DataDog, but also security companies like CrowdStrike. The final area is application software area which Mersch notes will incorporate AI directly into end user tools, though he doesn’t name any specific companies in that area.
“It’s a really exciting time to cross to invest across the entire AI stack,” Mersch says, “It hasn't showed up in earnings materially for a lot of these players. And I think over the next couple of quarters is going to be a major inflection point, whether it's cost savings, or figuring out different ways to really tack on additional revenue streams.”
