The concept of investing to the effects of technological disruption and innovation took its lumps in 2022 as the Federal Reserve set out on one of the most intense interest rate-tightening campaigns in recent memory. Thanks to large- and mega-cap growth stocks, the innovative thesis was restored in earnest last year and those good vibes have carried over into 2024.
While the magnificent seven stocks have posted jaw-dropping returns, likely to the satisfaction of clients that are heavily allocated to domestic large-caps, it’s human nature to ponder “What if?” and “What’s next?” Both are reminders that many investors would like to get in on the ground floor of something big. That’s solid reasoning because Amazon, Apple, Microsoft and Netflix were “old” public companies when they made their ways into the S&P 500.
Of course, there are other considerations. Advisors that have been in business in awhile know that with the advent of each new technology, criticism, fear and resistance often follow. It happened with the cell phone, online shopping and many more examples. And it's happening with five technologies—artificial intelligence, blockchain, DNA sequencing, energy storage, and robotics.
Indeed, large companies can and will continue innovating. The likes of Alphabet, Apple, Microsoft and Nvidia, among others, prove as much. However, with small-cap valuations depressed and the possibility of interest rates declining, there’s a case for evaluating smaller innovative companies,
Why Rates Matter
As noted above, 2022 was a grim year even for large- and mega-cap growth stocks due to rising rates. Advisors can effectively explain that clients by noting growth companies’ cash flows are longer-dated, making those cash flows less appealing when bond yields rise.
That scenario is amplified with smaller disruptive innovators because many of those firms, regardless of underlying industry, aren’t yet profitable. Making that situation worse is the point that many need to borrow capital to forge ahead with research and development efforts, but borrowing when rates are high is unattractive or downright punitive for smaller, money-losing companies.
While there is precedent for innovative companies experiencing market capitalization attrition at the hands of higher rates, there’s also precedent confirming the disruptive theses underpinning some of these firms wasn’t harmed by Fed tightening.
“In the eight years between 1995 and 2002, the Federal Reserve Bank conducted two rate-hiking cycles, increasing the policy rate from 3% to 6% between 1994 and 1995 and from 4.6% to 6.5% between 1999 and 2000,” notes Anqi Dong of State Street Global Advisors (SSGA). “During the same period, internet services and infrastructure stocks saw seven of their largest yearly drawdowns ever. But none of those reversed the exponential increase in internet users and internet use cases that supported the industry’s incredible growth, which ultimately drove its outperformance over the broad market and the broader Technology sector in the subsequent 20 years.”
Something Else for Advisors to Consider
With technology representing the largest sector weight in a variety of large-cap indexes, chances are some advisors might as though client portfolios are adequately or over-allocated to that group. On the other hand, there’s a reasonable chance that those portfolios are also under-allocated to innovation in its purest form.
That’s worth noting because some large-cap technology firms, though not necessarily the magnificent seven, are at risk of being unseated or even obliterated by more nimble upstarts in the innovative realm. That could imply more attention needs to be paid to smaller disruptive firms.
“Innovative companies are also underrepresented in traditional growth style benchmarks, as shown in the chart below. One reason for this is that the most commonly used financial metrics for constructing growth/value indexes — including price-to-earnings, price-to-book, and historical sales growth — are often backward-looking or shortsighted and don’t reflect a company’s creativity or potential for future growth,” concludes Dong.
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