The tech sector is currently a tale of two cities. Though hardly as perilous as Paris in Charles Dickens’ historical novel of the same title—where countless unfortunate souls lost their heads to the guillotine—one of the sector’s investment cities involves distinctly more risk than another.

That higher-risk city is Megacap Metropolis, populated by huge tech companies with elevated valuations. The other, occupied by large and small tech firms alike, is home to stocks characterized by reasonable P/Es and other low-risk fundamentals.

I call this the City of TARP—tech at a reasonable price. Some TARP companies are familiar names, but others are smaller concerns that, despite their positive metrics and clear growth potential, may not get a second look (or even a first) by advisors fearful of Nasdaq small-cap-itis—a disease endemic to many small, profitless tech firms with astronomical P/Es.

Eclipsed By Megacaps
Smaller TARP companies have trouble getting investors’ attention amid the loud buzz of big tech names that individual clients and many advisors tend to obsess over. For example, ever hear of Diode or Jabil?

By contrast, the din from megacaps seems to be off the decibel meter scale. The Bank of America Fund Managers Survey in May found that long big tech was the most crowded trade and, more significantly, that allocations to big tech had shown the biggest two-month jump since 2009. The survey findings reflect an all-too-common mentality: If you’re not invested in big tech, you’re not really in tech.

Capitalizing on the current megacap buzz, tech funds are advertising heavily. In a satiric yet direct appeal to individual investors, big-tech poster child ETF QQQ is relentlessly running an ad on financial channels with the clever conceit of a rube fund investor walking into a tech company lab and presumptuously asserting ownership.

In recent months, as the internals of the overall market have been weakening, the performance of megacaps Microsoft, Google, Amazon and Apple have been quite strong.

Microsoft, Google and Amazon have been touting their development of artificial intelligence to exploit the current obsession with anything AI.

Chanting the AI mantra has doubtless pushed up these companies’ prices and, in turn, the cap-weighted S&P 500, though only about 40% of the index’s members were above their 50-day moving average as of mid-May. And more recently, the lower end of the tech sector has accounted for the worst performers in the index.

Absurd Tail
The S&P 500 is now a dog being wagged by an absurdly large tail, and growth funds, by an even bigger tail. An astonishing amount of this cartilage is from shares of Microsoft and Apple.

As of late May, Microsoft was up 34% year to date with a P/E of about 35 (compared to the S&P 500 average of 24), and a market cap of about $2.4 trillion. At the same time, Apple was up more than 39% YTD, with a P/E of nearly 30. (Apple’s market cap of about $2.7 trillion exceeds that of the entire Russell 2000.)

These two companies are dominating passive growth ETFs to the point where most other holdings are just along for the ride on a boat loaded with concentration risk. In the iShares Russell Top 200 Growth ETF (IWY), for example, Apple and Microsoft accounted for more than 29.2% of total holdings as of mid-May. In the Vanguard Mega Cap Growth ETF (MGK), this figure was 29.9%.

This lopsidedness isn’t just limited to passive funds. As much as 25% of the holdings of some active growth ETFs—e.g., T. Rowe Price Blue Chip Growth ETF (TCHP)—are shares of Microsoft and Apple.

Hidden Merits
Investors are more likely to hit advantageous tech targets with a rifle than a shotgun, as scattershot blasts aren’t likely to hit anything but megacaps. Their dominance makes it hard for generalist advisors to pick out promising companies that aren’t priced up or, after doing so, to convince clients of their merits.

And even when advisors are more discerning, they’re often hamstrung by indiscriminate sector assessments by analysts that paint most tech companies with the same broad brush. Competitive scenarios of tech subsectors such as semiconductors are more varied than many broad-sector analysts apparently realize, especially if they don’t know an electron from a proton.

My firm determines TARP status by regularly putting about 350 tech companies through proprietary screens for 20 fundamental risk metrics. Those that emerge are then screened for momentum of performance metrics and growth potential, using FactSet data.

Semiconductor-related companies are among some of the currently most attractive TARP stocks (especially the larger companies), as they were in early 2022, after the bear market had set in. Current TARP names include some large (but not megacap) companies: Applied Materials, KLA Corp., Texas Instruments, Cisco Systems and NXP Semiconductors NV.

Current non-semi TARP stocks are in fields including specialty hardware, software and IT consulting. Among smaller TARP companies, under $1.5 billion market-cap, these stand out:

• Jabil (JBL), electronic equipment, instruments and components. With a trailing 12-month P/E of 11.4, the company has a five-year annual earnings growth projection of more than 20%. ROE, about 39%.

• Hackett Group (HCKT), IT services. ROE, a whopping 70%. Trailing P/E, 14.7%. Projected annual earnings growth, nearly 16%.

• Diodes Incorporated (DIOD), semiconductor equipment. Trailing P/E, 11.5. Projected earnings growth, 9%. Debt-to-capital ratio, a rock-bottom 9.7%.

• NetApp (NTAP), hardware, storage and peripherals. Trailing P/E, 10.9%. ROE, a whopping 154%. Projected annual earnings growth, about 6.5%.

• MACOM Technology Solutions (MTSI), semiconductor equipment. Trailing P/E, 13.6. Projected earnings growth, 11.3%, ROE, 39.3%.

• FLEETCOR Technologies (FLT)), IT services. Projected annual earnings growth, 13%, ROE, 37.4%. Trailing P/E, 17.4.

In investing, as in traveling, the best experiences are sometimes found in lesser-known towns off the beaten path.

Dave Sheaff Gilreath, CFP, is a founding principal and CIO of Innovative Portfolios, an institutional money management firm, and Sheaff Brock Investment Advisors. Based in Indianapolis, the firms manage assets of about $1.3 billion. The companies mentioned in the article may be held by those firms, Innovative Portfolios’ ETFs, affiliates or related persons.