When most people think of technology stocks, giants like Apple or Microsoft usually come to mind. But investors who stick only with bigger U.S. names may miss out on opportunities among innovative small and midsize up-and-comers with attractively priced stocks, according to Zachary Shafran, longtime manager of the Ivy Science and Technology Fund.

“Some of the best growth opportunities are rooted in innovative companies that create and discover brand new products and services,” says the 47-year-old manager, who has been at the helm of the fund since 2001. “Roughly 25% of economic activity in the developed and developing worlds is related to advances in science and technology. Small and midsized companies are a big part of that.”

In addition to exploring the smaller side of the tech stock universe, the $3 billion all-cap offering differs from both the tech indices and its mutual fund peers in a number of other respects. Its menu includes overseas stocks, and while its main focus is technology, it also maintains a foothold in companies that stand to benefit from technological advances, such as those in the health-care sector. Moving heavily into cash can also be a part of its strategy when Shafran isn’t finding many buying opportunities or has concerns about how a weakening economy could affect portfolio companies.

With its wandering ways and broad investment mandate, the fund often doesn’t perform in step with the major tech or broad market indexes. Weighed down by hefty stakes in tech giants, which have lagged the market for most of the last year, the SPDR Technology sector exchange-traded fund (XLK) returned 4.97% for the year ended August 31, versus 18.53% for the S&P 500 and 31% for Shafran’s fund. The Ivy fund has landed in the top 4% of its peer group over the last three years and in the top 12% over the last five years.

Its unique attributes have also led to underperformance when large-cap technology names lead the charge, as they did in 2009 and 2010. “Given its more diversified nature, this fund will not capture the full upside of a rising technology market,” wrote Morningstar analyst Flynn Murphy in a report earlier this year. “But capable management and good defense in market declines make this a worthy holding.”

Still, to investors still smarting from the tech stock bubble over 13 years ago, talk of diversifying through promising upstarts with trailblazing products or services might evoke memories of shoestring ventures and questionable business models. That perception, however, does not reflect today’s more grounded market in the small and mid-cap technology and science space, says Shafran.

In the late 1990s, there were few cases where the valuations of most companies were justifiable, he observes. By contrast, today’s market offers buying opportunities in a variety of businesses with a clear and predictable path to growth, strong management, and products and services poised for expansion in their respective markets. According to the fund’s most recent fact sheet, information technology and health-care companies account for 62% and 22%, respectively, of the value of equity holdings. The rest is invested in a mix of industrial, telecommunication, consumer discretionary, materials, consumer staples and energy companies. U.S. stocks account for 85% of equity assets, with the rest going toward companies in South Korea, Switzerland, China and other foreign countries.

Although a median market capitalization of just $2.2 billion points to the powerful influence of small and mid-cap stocks in the fund, the portfolio also holds large and mega-cap names such as Micron Technology, the fund’s top holding, as well as smaller positions in stocks such as Microsoft, Google and Apple. Shafran has added to or established some of those positions over the last year as their stocks lagged the market and their prices became more attractive.

Regardless of company size, price is always in the forefront of any buying decision for the portfolio, which typically owns between 45 and 65 names. The manager typically moves in only when stocks are selling at valuations that leave ample room for upside over his typical three-to-five-year holding period. Often, that happens when a setback or change in perception prompts a selloff.

Concerns about an overly optimistic valuation and possible investor retreat were one reason the fund passed on Facebook’s IPO last year. Even though the acclaimed Web site boasts millions of loyal users, Shafran and his team of analysts couldn’t see a business model that justified a $104 billion market capitalization.

Soon after the offering, the stock declined sharply as more investors began to agree with that view. Meanwhile, in the months that followed the IPO, conversations with advertising executives convinced Shafran that Facebook would eventually be able to monetize its user base through ad revenue and other channels. He was also impressed by growing evidence of the company’s appeal in foreign countries. A few months after the IPO, he established a small position in the stock at a price well below the initial offering price.

“A company doesn’t have to be profitable when we buy it,” he says. “But we have to see a clear path to profitability and management that is capable of executing those plans.”

To avoid tying the fund’s fortunes to a few stocks, Shafran typically initiates a position at anywhere from 0.50% to 3% of assets and will start trimming once it’s reached the 8% mark. He’ll also shift into cash when he can’t find a stock he likes or has concerns about the economy. That happened in 2008, when concerns about the impact an economic downturn would have on portfolio stocks led him to raise cash to a peak of over one-third of fund assets. The move helped limit the fund’s losses that year to 28%, compared to 45% for its typical tech fund rival.

A combination of attention to valuation, high cash stakes in down markets, and a broader investment universe than most tech funds has helped keep volatility in check and limited losses. The fund’s standard deviation is lower than that of both the S&P 500 and the fund’s Morningstar peer group, and over the last five years the portfolio has experienced roughly 80% of its typical peer’s losses in down markets.

“Compelling Opportunities”
While the underperformance of large-cap tech stocks since last year relative to broad market indexes has helped the fund shine against many of its peers, Shafran offers no predictions about whether those stocks will heat up again. “I’m not sure I’ll be sitting here at the end of the year saying technology stocks have outperformed the market,” he says. “But I do know that there are some compelling opportunities within the science and technology sectors.” Perhaps more telling is the fund’s 9% cash allocation—a level that indicates Shafran is keeping some money on the sidelines as he waits for bargains to pop up, but isn’t seeing red flags for the market as a whole.

Recent additions to the portfolio include EPAM Systems, an Eastern European software development and services firm with major clients around the world. Shafran believes the region’s talented, cost-effective labor pool is a big asset to the company and will help drive profits higher. The stock is one of several the fund is using to capitalize on the trend toward outsourcing information technology and business process. Another outsourcing play, India’s WNS Limited, has grown from a start-up with a handful of clients and a few shareholders to a true public company with a broad investor base and over 200 global clients. “It’s gaining traction in new geographies and new industries,” he says. “We believe the stock can go up 50% from here.”

A recent addition to the portfolio in the semiconductor sector, Microsemi, has seen its stock struggle recently because of the company’s relatively high debt load and ties to the shrinking defense industry, which accounts for about 20% of its business. Shafran believes the stock has been unjustly punished because its defense industry programs are less affected by sequestration than most, and the company has enough cash to pay down its debt.

Health-care holdings include Hologic, which specializes in women’s health diagnostic and surgical products, as well as medical imaging. While the company’s earnings growth has disappointed investors, Shafran believes new management could turn things around.

One of the fund’s large-cap holdings, Microsoft, re-entered the portfolio earlier this year. Shafran believes the tech giant will make better use of its huge cash resources when its new chief executive officer takes over and believes investors are underestimating its ability to innovate and introduce new products. “We often look for opportunities where there is a high likelihood of a change of perception, and this is one of them,” he says.

Another large company holding, Cisco Systems, has become more streamlined with a recent workforce reduction. “Even though Cisco is growing and has lots of cash, the stock is priced as if the company is losing ground,” he says. “We think there is an opportunity for improved valuations as people come to understand how well the company is positioned to be a primary beneficiary of an increasingly networked world.”