A group of small tech stocks is quietly dominating the FANGs after lagging behind for years. Here's why a Wall Street expert is convinced its gains are just getting started.

James Paulsen

A group of small, under-the-radar tech stocks has been outperforming their larger counterparts since June, according to Jim Paulsen, the chief investment strategist of The Leuthold Group.
He recommends that investors tilt their portfolios towards this cohort instead of the larger FANGs, which face a slew of risks including increased regulation.
A combination of valuation, volatility, and performance factors puts these stocks in a more favorable position, he said.
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Cabot Microelectronics, SolarEdge Technologies, and Viavi Solutions are all companies that you've probably never heard of.

They're the top constituents of the S&P 600 SmallCap technology index, and are among those positioned to outpace their larger, household-name counterparts in terms of returns. That's according to Jim Paulsen, the chief investment strategist of The Leuthold Group, a market research and money management firm that oversees more than $1 billion in assets.

For anyone considering buying tech stocks, he is flagging a prime opportunity to invest in small-cap companies with market valuations under $1 billion instead of the so-called FANGs that include Facebook, Amazon, Netflix, and Google parent Alphabet.

In his recent note laying out this investment case, he acknowledges that his proposition might be daunting for some investors.

After all, large-cap tech stocks have been among the safest bets throughout this historic bull market. They've delivered some of the strongest returns and earnings-growth prospects over the past 10 years.

Additionally, business spending on tech hardware and software remains strong even as the "old-era" manufacturing sector plunges deeper into a recession. And if this trend continues, it's plausible that the largest companies would benefit the most from demand for cutting-edge tech solutions.

But Paulsen is looking at these value propositions differently — and his conclusion is that smaller tech stocks could actually be the ones that dominate going forward.

He observes that they are already taking the lead from the big dogs. The S&P 600 tech index — which Paulsen dubs the MiniFangs — has been gradually outpacing the NYSE FANG+ Index after a long stretch of underperformance from late-2016 through June 2019.

Screen Shot 2019 10 09 at 12.37.10 PM

If this trend continues, Leuthold sees small-cap tech stocks gaining more notoriety and inflows from investors.

He goes beyond pointing out their recent performance to highlight a few other trends that could propel them higher.

Small-cap stocks are more compelling from a valuation perspective, he says, comparing S&P 600 technology stocks to their S&P 500 counterparts. His geo-weighted index of the forward price-to-earnings multiple, price-t0-book ratio, and price-to-cash-flow ratio for both indexes shows that smaller stocks have been cheapening since the end of 2013.

He also sees a compelling case to buy small-cap stocks based on their relative volatility. He concluded that S&P 600 tech volatility is a good leading indicator of price performance, based on the 120-day relative volatility of small- and large-cap stocks.

If you find these quantitative arguments insufficient, Paulsen has one more for you to consider: Smaller tech companies are not facing the same regulatory scrutiny as their larger brethren.

"Today, when it comes to technology stocks, while big may be beautiful, small may be smart," he concluded.

In terms of individual names, Brooks Automation, Power Integrations, and Itron are among the top-10 firms on the S&P index.

And, Invesco's S&P SmallCap Information Technology exchange-traded fund tracks the index it is named after.

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