Small-Cap Technology Stocks May Be Good Recovery Play

Investors typically look to small cap stocks as the leaders out of a recession. More nimble than their large-cap counterparts, small cap companies are quicker to adapt during both economic downturns and periods of recovery. That’s particularly true in the technology sector, where innovation and emerging market segments provide opportunities for rapid growth.

Analysts point out that small cap tech stocks haven’t exactly been flying high lately, but if the economy improves as expected in the second half of the year, those stocks are better positioned than their larger counterparts to outperform the market.

"The small caps have an ability to grow much more quickly in this environment," says Mark Conley, director of research at Broadpoint AmTech. "There are a few mega-technology companies out there right now going through the cost-cutting mode and doing a good job with that and driving earnings growth, but their top lines are not going to accelerate anywhere near the amount of some of the small caps."

Analyzing the Market

Small cap tech stocks may provide significant opportunities for investors, but the trick is determining which ones are primed for growth. For Conley, companies with strong product cycles are especially attractive.

"The companies with the better products are always going to gain share," he says. "As some of the bigger technology companies have less room to grow, they will look for potential acquisition candidates. The logical companies to acquire are the ones gaining the most and with the best products."

Within the semiconductor space, Conley cites Cypress Semiconductor and Monolithic Power Systems as companies with good product cycles.

"Q1 marked the bottom in terms of revenue, gross margin, and profitability," Conley says. "Monolithic’s revenue guidance for next quarter is up 30 percent sequentially from Q1. These are high-quality companies you can own in a recovery."

Erik Suppiger, senior research analyst at Signal Hill Group, says it’s important to identify fundamentals that are more specific to small-cap tech companies, noting that a larger company’s performance is often driven more by market growth than competitive dynamics. Companies with high gross margins, strong cash flow, and little debt on their balance sheets are particularly attractive.

It’s also important to note that small caps emphasize non-GAAP earnings in their quarterly statements. Ian Gilson, senior analyst at Zacks Equity Research, says that even if GAAP earnings are negative, small caps with strong non-GAAP results are worth a look.

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"It better reflects their internal planning and operating characteristics than the GAAP numbers," Gilson says. "I like to see non-GAAP earnings that are positive and, once we get through this recession, will be increasing at better than 10 to 12 percent per year compounded."

Gilson also cautions against extreme bargain hunting.

"Since we are dealing primarily these days with an institutional market, the stocks have to be above $5," he says. "Below $5, institutions don’t like to own those stocks and it gets to be an individual market, and individuals no longer have the power to drive stocks upward."

Capitalizing on Current Trends

Paying attention to market trends is a crucial factor in determining which small cap tech stocks are primed for growth. The networking sector, for example, is undergoing a significant shift, as companies such as IBM and Hewlett-Packard are encroaching on Cisco’s turf.

Suppiger notes that Cisco has long been able to maintain its dominant position because its smaller competitors didn’t have the scale and support that Cisco could offer. But that’s changing—to the benefit of smaller networking companies.

"One of the themes we’ve been working with is [small-cap companies] looking for prospective partners they can work effectively with that compete with Cisco now," Suppiger says. "Even in a challenging economy like we have, there’s opportunities for some of the smaller cap names to find partners that can generate some good growth opportunities in spite of the economy."

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Suppiger and Conley point to Brocade Communications Systems , which supplies data center networking solutions, as one such company. Brocade recently expanded an OEM agreement with IBM to include several Ethernet products for enterprise networking environments.

"There are very few companies you can find with a growing revenue base and a very attractive margin profile," Conley says. "[Brocade has] high-50s gross margins, which is very attractive. The OEM deal with IBM will contribute to the growth of their business, as well. That stock is less than nine times our 2010 earnings estimate. That’s a stock that can grow very rapidly through the rest of the year."

Emerging technologies also represents an opportunity for investors looking for small cap plays. Broadpoint AmTech recently upgraded two solar power companies to "buy" ratings: SunPower and JA Solar Holdings , a Chinese solar cell manufacturer.

Conley says that although 2008 was a dreadful year for solar technology companies, improvements in the financing environment should help propel these stocks for growth in the second half of 2009.

"SunPower has significant share in the U.S. utility market, which will most likely become the most important market in solar in the next two years, so they’re well positioned for that," Conley says. "JA Solar just reported a dismal quarter. However, they do have an agreement in place with BP Solar, which will begin to ramp significantly in the back half of the year. They were running very low utilizations in Q1, but that’s going to ramp significantly in the back half, so their margins will improve as revenues improve."

(Editor’s Note on Disclosures:Erik Suppiger of Signal Hill Group does not own shares in Brocade or Cisco.)

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