After ten years of growth in Nasdaq 100, what is next for technology stocks? What may be suitable tech indexes to consider as of today?
$QQQ, $RYT, $PSCT
TLDR: As discussed in our last entry, Nasdaq 100 may not be the best investment right now; half of the index is dominated by six companies (FAANG) which are big and have too outsized a valuation to produce impressive returns in the next few years. But an investor still needs to invest in technology to avoid missing out on compelling secular growth areas of cybersecurity, artificial intelligence, digital transformation, and industrial automation. One can pick individual stocks or invest in a technology index focused on small cap stocks or equal weightings for all tech stocks.
What comes next in technology?
One can argue that the growth in the last 10 years in companies like Google, Amazon and Apple have been due to trends of digital advertising, cloud, mobile phones and electric cars and that these trends are well reflected in stock prices. So what is next in technology? Incidentally, a new tech wave is underway.
Technology is permeating the different business sectors ranging from agriculture to food service to warehouses, among others. Companies like Deere are combining software and their products to offer subscription services, much like Software as a Service(Saas) companies. We argue that there are secular growth trends in technology in digital transformation, industrial automation, cybersecurity and artificial intelligence.
Industrial Automation
A decrease in labor participation (aka folks retiring early), declining population growth, and falling immigration has every industry in this country and in the western world looking for labor. Industries from food service to the automotive industry are focused on reducing manual labor via automation and robotics.
An increase in reshoring thanks to geopolitics has inspired governments all around the world to bring supply chains domestic or re-route them to friendly countries. Recent legislation like the CHIPS and the Science ACT and the Inflation Reduction aim to bring manufacturing back in North America. As manufacturing chips in the USA will not be as cheap as in Asia, industries will invest even more in automation.
Artificial Intelligence
Yes, ChatGPT is the one in the news, but there are other big applications of artificial intelligence already in everyday use such as video surveillance via computer vision, automated customer support via chatbots, and fraud detection in the payments industry. These different AI technologies are going to keep permeating our daily lives in the next decade.
Digital Transformation
Along with the demand for increased automation and productivity, the need for digital transformation (aka modernizing B2B software applications) is not going away. One can refer to the recent Southwest airlines episode where the company had to cancel 16,700 flights costing up to $825 million in addition to reputational damage. A lot of enterprise software applications need to be modernized for the new era to match the complexity, scale and security requirements of the new era.
Cybersecurity
Finally, cybersecurity is going to be a big challenge for consumers and corporations.. According to Mckinsey, damage from cyberattacks will amount to about $10.5 trillion annually by 2025—a 300 percent increase from 2015 levels. It seems a reasonable bet that growth in cybersecurity software is a secular growth theme.
Starting in our next blog, we will discuss opportunities in these secular growth areas.
If not Nasdaq 100, which other tech indexes can one consider?
So now that we understand that it may be prudent to not avoid investing in the technology sector, one can consider some options. Either one can invest in individual stocks, or one needs to find an index which is not dominated by the FAANG to find likely superior returns.
One pathway is to invest in smaller companies who are still undiscovered and have a longer runway for growth. According to academic research by Nobel laureate Eugene Fama, small cap companies outperform market indexes over an extended period of time.
Small caps also lead the large companies after a recession. According to research by Raymond James (link), small caps have outperformed large caps every time for the last nine recessions. In the first year following a recession; small caps returned 34% and large caps returned 18% - an outperformance of 16%!
Taking another view, research by CME group shows that small caps outperform large caps during periods of economic turbulence (1979-83, 1990-94 and 1999-2014). From 1999-2014 - the period of the tech bust, Iraq and Afghanistan war and the financial crisis - the small caps outperformed the large caps by 114%. In the relatively peaceful period since 2014, small caps have lagged behind the large caps.
The above studies makes a strong argument to favor smaller companies vs larger companies in the technology sector. These studies support the hypothesis in the last entry, that investing in the large-cap tech index Nasdaq 100 after the bull market of the last ten years may not be as lucrative in the coming period.
Luckily, there are some other ways to invest in small companies in the technology sector. Standard & Poors Global offers different indexes - one is S&P 600 Small Cap Tech Index (Market Cap Range $850MM- $3.7B), another is S&P 400 Mid Cap Tech Index (Market Cap Range $3.7B - $14.6B) and the last is S&P Equal Weighted Index, where each tech company is given an equal weighting.
In fact, recent data over the last one year shows that Nasdaq 100 powered by the FAANG, has started to lag behind the small-cap and equal weighted indexes. Once trends start, they can last for a while.
Retail investors, if they want to avoid large tech, may consider investing in a small cap index, and for investors who still want some exposure to the large cap companies may consider investing in an equal weighted index.
Unfortunately, not many ETFs exist in the small, mid-cap technology sector. There are only two ETFs, offered by Invesco, one tracking the S&P Small Cap Tech Index (PSCT) and another tracking the Equal Weighted Index (RYT). No ETF tracks the Mid Cap Tech Index. Small Cap (PSCT) and Equal Weighted technology (RYT) are both good candidates for investors looking to invest in technology.
Starting in our next blog, we will discuss individual companies in areas of industrial automation, cybersecurity and other growth areas. Stay tuned!
Disclaimer:
This blog is solely for informational purposes and is not intended to be a solicitation to buy or sell any particular security. We suggest you check with a broker or financial advisor before making any investing decisions.
The author is affiliated with Tilden Path Capital, registered as a Registered Investment Advisor in California.
Past performance is no guarantee of future returns.
All investing involves risk and possible loss of principal.
In our analysis, we use third-party resources we believe to be reliable, but cannot guarantee the accuracy of such information. We believe the information we provide is accurate as of the date furnished, but we do not revisit past material to update it.