Forget FANG and Buy These “SMID” Stocks Instead

As it staggers and wheezes its way ever higher, this aging bull market is about to collapse from exhaustion. Now hovering at excessive valuations, the broader market is getting much of its momentum from the so-called FANG stocks of Facebook (NSDQ: FB), Amazon (NSDQ: AMZN), Netflix (NSDQ: NFLX), and Google parent Alphabet (NSDQ: GOOGL).

It’s known as “bad breadth” and it’s a classic red flag for an imminent correction. As Jim Pearce, chief investment strategist of Personal Finance, explains:

“The quartet of high-tech ‘FANG’ stocks is driving the stock market to record heights, despite the fact that two of them are only marginally profitable.

While Facebook and Google trade at relatively modest premiums to the overall market based on their actual net income, Amazon and Netflix are priced at earnings multiples nearly eight times that of the S&P 500 Index.”

Why take a risk on tech stocks trading at nosebleed valuations? If you’re leery of over-hyped Silicon Valley darlings, consider reasonably valued smaller tech companies with greater room for growth. I’m particularly impressed by two aerospace/defense electronics firms with small- to mid-cap valuations — a category that I like to call “SMID.” I examine these two equities below.

BlackRock gets busy…

But first, if there’s any doubt that SMID stocks are hot, consider the following question that I received this week from a reader:

“The iShares Russell 2500 ETF SMMD was launched on July 7. Any advice or wisdom on this newly offered fund?”—Darryle

Darryle, from my perspective, the market for broad-based exchange-traded funds is saturated. Nonetheless, behemoth BlackRock (NYSE: BLK) seems intent on expanding its empire with more offerings. Hence BlackRock’s launch of the iShares Russell 2500 ETF (SMMD), which provides exposure to small- and mid-cap stocks by tracking the Russell 2500 Index.

I actually think this year will prove a boon for smaller companies, but the launch of SMMD begs the question: is this fund really necessary? SMMD holds 491 stocks, with holdings from the iShares Russell 2000 ETF (IWM) providing the bulk of small-cap exposure. In fact, IWM represents nearly 44% of SMMD’s weight.

The purpose of SMMD is to provide even broader mid-cap exposure. There’s nothing wrong per se with SMMD and I’m a big fan of this category of stock, but the fund’s sector weightings are less diversified than those of IWM, with the former top heavy toward financials (about 52%, compared to 17.5% for IWM).

I prefer IWM, which is why we’ve added it to the PF Fund Portfolio (I serve as managing editor of Personal Finance).

Catch a rocket stock…

Astronics (NSDQ: ATRO) and Esterline Technologies (NYSE: ESL) are two appealing companies that fall within the SMID category. I like these stocks because they leverage their in-house engineering prowess to create complex, proprietary products that larger aerospace companies can’t live without.

ATRO and ESL are “picks-and-shovels” plays that specialize in value-added tech for which they can charge a premium, which in turn protects their margins from the commoditization that eventually bedevils so many tech firms.

And you’ll never hear about these small fry on CNBC or the other financial news channels. These media outlets are little more than PR agencies for Wall Street operators with products to peddle; the investment advice from these yakkers is dubious at best. While the TV pundits prattle ad nauseam about FANG stocks, consider the following SMIDs.

With a market cap of $887.7 million, Astronics designs and manufactures products for the aerospace and defense industries around the world. It operates through two divisions, Aerospace and Test Systems.

The Aerospace division offers lighting and safety systems, electrical power generation, aircraft structures, and avionics products. The Test Systems division provides automatic test systems and training and simulation devices to aircraft OEMs.

As demand increases for the sophisticated electronics that guide and power military aircraft, Astronics should prosper in a year that’s expected to be dicey for the broader markets. That’s why we’ve added it to the PF Growth Portfolio’s Small Cap sleeve.

Wall Street expects Astronics to post year-over-year earnings growth of 22% next quarter, 14.9% in the current year, 16.8% next year, and 12.5% over the next five years (on an annualized basis). The stock’s trailing 12-month price-to-earnings ratio (P/E) is 19, roughly in line with the trailing P/E of the aerospace/defense sector.

With a market cap of $2.9 billion, Esterline designs, manufactures and markets engineered aerospace products for commercial and defense customers in the U.S. and internationally.

The company’s products include electronic flight bags (EFBs); global positioning systems; head-up pilot displays; temperature, pressure and speed sensors; electrical power switching; and control and data communication devices.

Emblematic of the movement toward lightweight electronics is the growing popularity of EFBs, which are increasingly replacing anything made of paper in the cockpit. The FAA has ruled that EFBs may serve as substitutes for the paperwork that pilots are required to carry with them into the cockpit.

Esterline is a play not only on EFBs but also on the tremendous multiyear demand for all types of aircraft electronics, with clients such as aerospace giant Boeing (NYSE: BA).

Next to defense industry titans such as Boeing, Esterline seems puny, but like Boeing, this aerospace electronics company straddles both the defense and commercial aviation industries. Plus, Esterline is a mid-cap momentum play on not only military aircraft spending but also technological disruption in the cockpit.

Along with cockpit avionics for military aircraft, the company also makes combat-hardened personal communication equipment, primarily headsets. With more money budgeted for these items this fiscal year, the Pentagon is becoming Esterline’s personal cookie jar.

With a trailing P/E of 21.5, ESL’s valuation is roughly in line with its peers and attractively priced considering its growth prospects. The average analyst expectation is that Esterline will post year-over-year earnings growth of 9.5% next year and 10.3% over the next five years (on an annualized basis).

Comments or questions? Drop me a line: — John Persinos

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