Following an exceptionally tough year for small cap tech stocks in 2022, we’re finding select opportunities in companies with strong long-term growth prospects, with semiconductor equipment looking generally more appealing than software.
Are semiconductor stocks diamonds in the rough?
To meet the surge in demand during the pandemic, semiconductor companies ramped up production only to find themselves sitting on excess inventory throughout much of 2022, as supply chain issues, slowing demand and cancelled orders combined to create powerful headwinds. The majority of semiconductor and semi capital equipment stocks saw significant compression in earnings multiples, as stock prices dropped in anticipation of a market slowdown and future downward earnings revisions. Entering 2023, the sentiment on semiconductor stocks seems overly pessimistic to us, presenting a favorable risk/reward backdrop.
One area of particular interest to us is manufacturers of silicon carbide (SiC) power devices, which are experiencing massive growth due to their use in electric vehicles. Large cap companies such as Infineon Technologies are known for SiC manufacturing, but we are finding interesting opportunities in small caps that make manufacturing equipment. Our team is closely monitoring the industry for a pickup in supply versus demand. We are looking to opportunistically add these and other semiconductor stocks given today’s attractive valuations relative to the historic norm.
In our view, semiconductors are undervalued relative to historic norms.
Software companies could use some polish
Small cap software companies provide services ranging from staffing and revenue cycle management to security and supply chain logistics. Within the technology sector, software usually lags late into a cyclical economic slowdown, coincident with a decrease in enterprise spending. Software stocks declined sharply in the first half 2022, then recovered into the end of last year, but are once again under pressure entering 2023.
Even in this environment, many small cap software companies demonstrate strong revenue growth and generate cashflow. The category has experienced significant multiple contraction, but with a softening economy, we anticipate even more downside pressure on fundamentals. With slowing enterprise spending, the risk of ebbing revenue growth is high, and we believe future downward estimate revisions will likely continue to weigh on software stock prices heading into 2023. Although the risk/reward mix for the industry has improved, our small cap growth portfolios are cautiously positioned in software.
Given slowing enterprise spending, we believe the risk of ebbing revenue growth for software companies is high.
Separating the wheat from the chaff
Valuations of small cap stocks relative to their large cap cousins remain near 20-year lows, and forward earnings growth expectations continue to favor smaller companies as we head into 2023. We’ve trimmed back on our solid performers and are taking a fresh look at underperforming stocks of companies where investor sentiment is waning but fundamentals remain strong.
Our team continues to be prudent in adding new names to the portfolio. We prefer companies that look promising in terms of 2023 earnings growth in order to avoid negative earnings revisions. We continue to favor industrial and technology sectors, while remaining cautious toward consumer staples and certain smaller sectors like utilities, real estate and communication services. We also maintain our investment philosophy focused on identifying companies with double-digit revenue and earnings growth potential that are trading at attractive valuations.
We favor industrial and technology sectors, while remaining cautious toward consumer staples, utilities, real estate and communication services.