MORGAN STANLEY: Internet companies could be stuck 'in the penalty box' for a while - here are the corners of tech we'd rather own

Reuters/Nick Didlick

• Large internet companies like Facebook and Alphabet are under scrutiny for how their users' data is handled.
• Morgan Stanley's equity strategists are among those cautious on internet stocks.
• Instead, they're recommending two subsectors that aren't facing the same turmoil.

Tech companies have taken a beating in the stock market of late, but Morgan Stanley's equity strategists are cautioning about lumping them together.

The chief concern has centered on how Cambridge Analytica used Facebook users' data that had been gathered in a personality quiz to target US voters for the 2016 election. It's raised concerns of more regulation on large internet companies, which are already in the crosshairs of European authorities.

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"We saw early signs of some weakness in internet stocks around 4Q17 earnings and more recently have seen rising worry of regulatory risks," Mike Wilson, Morgan Stanley's chief US equity strategist, said in a note Monday. "The fundamentals may well be fine long term but we think the group may remain in the penalty box for some time."

Although regulatory action may be held off until after the midterm elections in November, data and privacy issues could remain front and center of the public's attention, Wilson said. Facebook CEO Mark Zuckerberg will testify before Congress this week.

"We prefer Hardware and Software on the back of continued robust capital spending intentions and CIO survey results from our analysts showing rising spending expectations in these categories," Wilson said. He touted Microsoft and Cisco as specific recommendations on Morgan Stanley's "Fresh Money Buy List," which highlights the firm's top stock picks over the next three to six months.

Wilson and his colleagues downgraded the entire tech sector in February from "overweight" to "equal weight." At the time, they cited a decline in relative earnings revision breadth, or the comparison between companies upgrading and downgrading their earnings forecasts.

They also observed that when mega-cap companies outperform the broader stock in a given year, like 2017, they historically have not managed to repeat that same performance the following year and even underperform the market in some years.

The mixed views on various subsectors within tech don't equal a call to be bearish, Wilson said. He said he hasn't seen evidence that institutional investors are throwing in the towel even after the recent drop in prices.

One risk to the sector remains a US-China trade war, although Wilson is betting that tensions will ultimately ease.