• Big Tech stocks have driven the market to record highs this year.
  • But Makena Capital’s Larry Kochard likes small-cap, mid-cap, and quality stocks instead.
  • He cites concerns over earnings growth sustainability, antitrust issues, and increasing competition.

The stock market is on a Big Tech-fueled tear as equities continue to hit record highs this year.

But with broader indexes looking expensive, Larry Kochard, a co-CIO at $22 billion Makena Capital Management, is eyeing three areas of the market outside of the Magnificent Seven.

He favors small-cap, mid-cap, and quality stocks over the Big Tech mega-caps leading the market rally for three reasons.

One is that the earnings winning streak that Magnificent Seven stocks have enjoyed is simply difficult to keep going. In the first quarter of this year, Magnificent Seven earnings grew by 50% annualized year-over-year, according to Ned Davis Research. For the rest of the 493 stocks in the S&P 500, earnings grew by 0.3% in that time. Wall Street estimates Magnificent Seven earnings will grow by 28% year-over-year in Q2.

"Large-cap stocks are very expensive," Kochard told Business Insider in a June 25 interview. "With that said, their earnings have been growing at a rate that has supported those valuations. The question is, can those earnings continue to grow at such rates? I think it's unlikely."

Another reason is that the larger these companies grow, the more antitrust scrutiny they draw, Kochard said. The Justice Department has already brought antitrust charges against Apple and Google in recent months, and firms like Microsoft and Nvidia are being closely watched by regulators. Many Big Tech companies are facing antitrust lawsuits from the European Union as well.

And finally, large firms dominating a lucrative field like AI will eventually face competition, which lowers prices.

"It's just basic economics," he said. "If someone is earning monopoly rents, at some point, a competitor comes in."

Why smid-caps and quality?

Small- and mid-cap companies are cheap right now as the market focuses on the mega-caps, making it an ideal time to buy, he said. When it comes to innovating and adapting, small and mid-cap companies' size gives them a relative advantage. These companies can partner with activist investors to affect change in business operations and realize efficiencies faster than large companies, he said.

Kochard likes quality stocks due to their strong financial profile and ability to perform under cyclical market conditions or economic downturns. Quality stocks have resilient business models and track records of profitability, cash flow, and low debt. Companies unburdened by interest payments on their debt can use their cash more effectively by reinvesting in their businesses or returning value to shareholders through dividends.

It's true that the Magnificent Seven fits into this categorization, as large companies typically have less debt than smaller ones. That doesn't mean size and quality are exclusive, though. "There are higher quality companies within the small and mid-cap universe that have just been thrown out and ignored," Kochard said.

It's also important to consider quality and price in tandem, especially considering how elevated certain stock valuations have gotten. "At some point, you pay too much for companies that are valued at a certain level," he said. "Unless they grow, it's not going to be a great return."

Investors can gain exposure to small-, mid-cap, and quality stocks through funds like the Vanguard Small-Cap ETF (VB), the iShares Core S&P Mid-Cap ETF (IJH), and the GMO U.S. Quality ETF (QLTY).