(Bloomberg) -- Being involved in a “crowded trade” is one thing that’s sure to keep investors up at night. In other words, a position that has become so popular that there are few people left to get involved with it — which could mean painful losses if traders decide to rush for the exits.

That’s why microcap stocks can be appealing, according to PGIM Quantitative Solutions Managing Director Patrick McDonough. 

He joined the What Goes Up podcast to explain his approach to analyzing these smaller, younger companies whose values are often measured in millions — rather than billions — of dollars. He also discussed the overall state of play in markets at the end of a quarter that featured a massive rally in tech stocks.

Here are some highlights of the conversation, which have been condensed and edited for clarity. Click here to listen to the full podcast on the Terminal, or subscribe below on Apple Podcasts, Spotify or wherever you listen.

Listen to What Goes Up on Apple Podcasts

Listen to What Goes Up on Spotify

Q: We’ve had a strong rally in tech. What do you think is going on?

A: You’re seeing tech do really well. We’ve seen a reversal of the cyclicals that drove value last year. So at first glance it’s a nice simple value-versus-growth story with growth coming back. But if you peel that back a couple layers, what you’re actually seeing is fear — or at least uncertainty driving the equity market. And that’s being played out with these larger tech names that have done well in the past. But I don’t necessarily think you’re going to do all that well going forward in the space. So I actually think it’s a little bit more of a size effect that we’re seeing at this point, rather than actual growth in this case.

And the names that are doing it, it’s Apple, it’s Microsoft, Salesforce, Nvidia — these are really big companies. These are also really, really expensive companies. Nvidia, it’s more than 50 times forward earnings. So it’s hard to see how these are really growth companies. They’ve already come, they’ve already grown — in fact, you could argue they haven’t really grown for half a decade at this point. They’re just so big. If anything, they’re very profitable companies. But it’s kind of hard to see them as actual growth companies. And from a factor perspective — I can’t help, but I’m a quant, I have talk about this a little bit — these aren’t really growth companies. These are companies that are very, very consistent and persistent when it comes to an earnings perspective. So really not growth. This is a place to hide for equity investors at this point.

Q: Just what we’ve forever considered growth have grown into becoming the blue-chip defensive stocks that if you have to be long something, these are the names you go with?

A: Exactly. 

It’s not 2008 at least. It’s not a banking crisis, it’s not a financial crisis. Governments around the world have really stepped up and put a floor under financials. But it is a little bit of the market hoping that the Fed rising rates isn’t going to last and we’re going to see a reversal of that in the short term. Going back to 2018, the Fed started to raise rates, the market kind of freaked out a little bit. You saw the reemergence of the Faangs — Faangs 2.0 at this point coming back and everything else in the market maybe just hovered there or rolled over a little bit.

Covid put an end to that particular trade, but it was a last gasp of what had been almost a 10-year bull rally at that point. People looking for those companies that would be economically insensitive or at least agnostic to any downturn in the markets. 

You compare that to the fixed-income market, and wow, it’s two very, very different messages that we’re seeing right now. The fixed-income market right now kind of looks like Space Mountain at Disney World, right? You ride up the curve a little bit going up to the six-month, and then it rolls on down until the 10-year, 20-year, get a little bit of a bump going into the 30-year. But that’s not posed for a growth market. That’s not signaling happy landings or at least anything other than volatility going forward. Whereas the equity market right now is like, oh, it’s fine, we’re whistling past this particular graveyard and hoping that that continues forever I guess at this point. Hard to see that with rates in the short term right below 5%, but maybe we’ll have forever perpetual growth. But that seems unlikely.

Q: You’ve been looking into microcaps — how should we think about microcaps?

A: Part of this started out with trying to identify companies for that actual upside potential. If you think about it from pure economic growth, almost an academic study of getting back in to say like, hey, where are these companies with new ideas that have been overlooked or can come in and disrupt markets and actually disrupt. So we’re not going to pay for the Ubers and the Microsofts, or the Apples that have already come and disrupted and are now the established players. Where can you find some of those new places? And it started with tech and biotech. It was looking into what are the structures of those names, and is there an opportunity outside of the VC or private-equity space, and really realizing that the microcaps have been very overlooked.

Now there’s a lot of choppiness down there, there’s a lot of noise down there. You have to be very, very careful. You have to be very systematic or structured. I, of course, think quants are the answer to every question. But you really do have to be diversified and clean and structured in the way that you do it in the microcap space. But you also have the opportunity for other segments of the economy that aren’t really necessarily in vogue, so things like banks. You could actually diversify in financials. You can look at industrials that are actually down the real end of the economic spectrum, if you will, and get into that space in a more diversified way through microcaps. 

And it’s also something that is not really played in from a traditional-institutional-investor space. It’s something that people have historically avoided, whether that’s governance — you need to get another manager to look at it, or at least you assume you could get your growth from other segments of the market. Which means it’s not crowded. So it’s an area we can go in and get a lot of upside, even above just the pure beta in the microcap space. So very exciting from an opportunity set — at least in the long term. 

--With assistance from Stacey Wong.

©2023 Bloomberg L.P.