Key Questions: How Do We Invest in Tech? 

In the nearly 16 years since the S&P 500 bottomed in the wake of the global financial crisis (in March 2009), technology stocks have vastly outperformed the broader stock market, returning an annualized +20.9% versus +16.3% for the S&P 500 (as of 1/31/25), and as result, these stocks now represent sizeable allocations within many portfolios. In a companion piece, we ask the question, “Do you know how much tech you really own?” and seek to help investors understand their overall exposure to technology companies and offer our perspectives if such exposures are warranted.

In this piece, we discuss how we’re approaching investing in the technology sector, and shed light on our differentiated views.

Starting with the “top down” and focusing on portfolio construction, our investment approach is informed by two macro views: 1) we don’t think it’s appropriate to own all seven of the “Magnificent 7” stocks; and 2) we believe that the social media business model is likely going to come under increasing regulatory scrutiny going forward. We expound on each idea below.

The Magnificent 7 refers to seven very large stocks (large in terms of market capitalization), all of which are major players within the technology ecosystem and collectively make up ~35% of the S&P 500 Index. Given this level of concentration, we believe that investors need to make discreet choices about which to own/overweight and which to underweight/zero-weight.

Moreover, in our view, within the Magnificent 7, there are two distinct groups of companies: those that have business models that benefit from the continued adoption of technology at scale and those that do not.

The first bucket is made up of three companies with business models leveraged to cloud-based technology infrastructure along with the key enabler of the AI revolution. The second bucket is made up of business models that are challenged, and one individual company whose social media business model has proven ripe for disruption and could also face intense regulatory scrutiny, in our opinion. We have intentionally structured our portfolio to emphasize the first bucket and deemphasize the second.

Beyond the Magnificent 7, we see great value in many areas and note that the growing dependence on digital technologies, remote work, cloud computing, and automation has created a strong demand for specialized tech solutions. Investing in small- and mid-cap tech stocks with exposure to cybersecurity, observability, and DevOps platforms offer a distinct attractiveness compared to investing in the Magnificent 7.

Observability tools help teams monitor and analyze complex systems, and quickly identify and resolve issues to improve efficiency and performance of applications. DevOps tools use a comprehensive approach to promote collaboration, automation, and rapid delivery that enables organizations to create more reliable and efficient software. While the large-cap companies have proven themselves as reliable blue-chip investments, we favor smaller, more innovative companies that specialize in these high-demand sub-industries because of their higher growth potential, diversification opportunities, and their role in addressing key issues within the evolving tech ecosystem.

1. Superior Growth Potential

Small- and mid-cap tech companies are often earlier in their innovation cycle, potentially poised for significant growth. These companies tend to disrupt traditional markets or introduce new solutions to meet emerging needs. Cybersecurity is one example as it continues to experience rapid growth as organizations face increasing digital threats. Similarly, the adoption of cloud computing and the need for automation in development are driving the growth of observability and DevOps companies. We believe smaller tech companies in high-demand areas are well-positioned to experience significant revenue growth, as well as allowing investors to capitalize on cutting-edge technology solutions.

2. Innovation

Investing in SMID-cap stocks gives us exposure to innovation in emerging themes. They aren’t constrained by legacy systems or mass-market strategies and are more agile in addressing emerging trends or issues in the tech world. For example, a mid-cap company specializing in zero-trust security models or offering cloud-native observability solutions could be the next big player in the tech ecosystem. These tech companies often lead in niche areas, bringing specialized solutions that cater to evolving needs within the tech ecosystem.

3. Diversification

One of the most compelling reasons to invest in small- and mid-cap tech stocks is the level of diversification they provide within the tech sector. The Magnificent 7 stocks, despite their strength, are highly correlated and heavily weighted in the S&P 500 Index as noted above, making them vulnerable to a downturn simultaneously. Diversification across different sub-industries can help mitigate the risk inherent in investing in any single technology company or a group of companies that are highly correlated. SMID-cap companies provides some insulation from broader market downturns or issues that might affect larger companies whose businesses are intertwined.

Small- and mid-cap companies in the cybersecurity, observability, and DevOps sectors are on the frontlines of addressing the needs of businesses as they navigate a new era defined by technological transformation. Emerging trends provide a strong foundation for the growth of smaller tech companies, making them attractive investment opportunities. While the Magnificent 7 may offer stability and established dominance, they are not necessarily positioned to capture the full potential of emerging trends. With the greater growth potential, diversification, and focus on addressing the challenges of the digital transformation, smaller companies offer a higher potential for long-term capital appreciation.

For more information, please contact your advisor.