What should investors do with tech stocks now?

“Whatever the reason for last week’s slide – action in the derivatives markets, Tesla’s failure to make it into the S&P 500, the Fed’s no-longer-expanding balance sheet, worries about the lingering economic effects of the pandemic or a simple nod to racy-looking valuations – technology and growth investors now have three decisions to make,” says Russ Mould, AJ Bell Investment Director. “First, they have to decide whether the actual fundamentals of the firms have changed at all, in terms of their competitive position, balance sheet, management acumen or strategy. Second, they have to take a view on why the share prices suddenly fell and whether it was justified. And then they have to decide whether this is a chance to buy on the dips – yet again – or a call to lock in what could be substantial profits.

“In order:

•    It is pretty hard to argue that anything has changed fundamentally over the past week and we won’t know any more about near-term earnings until the latest quarterly announcements in October (unless there are any surprise pre-announcements in the interim). Until now, investors have been content to pile in – or at least buy-and-hold – in the view that Facebook, Alphabet, Amazon, Apple, Netflix and Microsoft (the FAAANM sextet) are proving relative immune to the recession that followed the pandemic and that their ability to keep growing earnings means they are a scarce commodity that deserves a premium valuation.

•    As legendary investor – and passive investing advocate – Jack Bogle once noted: “The idea that a bell rings to signal when to get in or out of the market is simply not credible.” Few if any bulls would have predicted where the FAAANM names would have got to this year (let alone Tesla) and bears have been run over by the phenomenal momentum gathered by the sextet, whose $7.5 trillion combined market cap is still equivalent to 26% of the S&P 500 index’s total value. It is therefore not clear why the FAAANM shares stumbled so badly last week and why gravity began to exert an influence. 

When valuations are so lofty – as some argue they are in this case – it takes little to create downward momentum and even tiny things like Tesla’s unexpected exclusion from the S&P500 index can make a larger-than-expected difference. It is certainly easy to make the case that the US stock market has become very lopsided. The FAAANM group’s $3 trillion market cap gain over the past 12 months represents 85% of the $3.5 trillion increase in the S&P 500 as a whole, which hardly looks healthy, at least so far as the other 494 stocks are concerned. Excluding the FAAANM names, the S&P 500’s market cap is less than 1% higher than it was in January 2018.

 
Source: Refinitiv data

•    In the absence of a clear reason why the FAAANM’s shed $594 billion in market value (or 7%) in just two trading days, investors must now decide whether this is time to top up, sit still or bail out. 

Trying to time the market and second-guess movements in share prices and shifts in sentiment is a mug’s game and most investors will therefore be tempted at least hold on, in the view that nothing has changed in terms of the six companies’ fundamental outlook. 

Having been burned several times already, it may be unlikely that any shorts will want to chance their arm again, but holders will also be left hoping that new buyers emerge. This may require further earnings positive surprises and upward forecast estimates, to attract momentum buyers and bolster the investment case that these six firms are indeed pretty much immune to the post-pandemic recession and that their rare ability to grow sales and profit means they are worth a premium valuation.

According to data from FactSet, the S&P 500 trades on 22.5 times forward earnings for 2020, against a five-year average of 17 times. However, that is in a year ravaged by a recession and if analysts’ consensus forecasts of 26% earnings growth in 2021 are met then the S&P trades on 16.7 times earnings for 2021. That may not be a knock-down bargain, at least relative to recent history, but that allows bulls to argue US equities are hardly overpriced either, especially when the US 10-year Treasury yield is just 0.72%.

By comparison, the six FAAANG names trade on 43 times earnings for 2020 and 35 times for 2021. That implies it will take the six companies 43 years to earn their market cap in net profit (and thus give investors all of their money back), assuming profits stay the same.

Clearly the investment case assumes further rapid profit growth from here, but investors are therefore already paying a big premium in valuation terms, in return for 4% earnings growth in 2020 and 24% in 2021. The consensus expectation is that there will be much more profits growth to come in the future, thanks to their dominant positions in their chosen markets and how the after-effects of the pandemic mean customers and clients may be even more inclined to use their services and products.

Source: Zack’s, NASDAQ, consensus analysts’ forecasts, Refinitiv data

But it is valuation – and the multiples paid to access corporate revenue, profit and cash flow streams – that ultimately determines long-term investment returns and another way of looking at the FAAANM valuation looks less comfortable.

On aggregate, the six names’ $7.5 trillion market cap is the equivalent of 7.1 times their forecast combined annual sales in 2020 and 6.1 times the same number for 2021. Again, the underlying assumption is that sales will keep growing for a long time to come.

Source: Zack’s, NASDAQ, consensus analysts’ forecasts, Refinitiv data

However, the FAAANM’s annual revenues estimated to top $1 trillion for the first time in 2021 there have to be questions over when the law of large numbers takes over, making it hard to generate the trend percentage growth rates to which investors are currently accustomed.

In addition, that 7.2 times sales figure means it would take the FAAANM companies in aggregate just over seven years to give investors their money back, assuming they returned 100% of their revenues as dividends, which simply isn’t possible, given the need to invest in research, marketing and staff, as well as pay taxes. Again, the underlying assumption is that sales will keep growing for a long time to come but second-guessing what will be happening in technology in seven years’ time is far from easy.

Such concerns could be dismissed by arguments that the six names are simply too strong and powerful to be unseated by any disruptive newcomer. Regulators could still have a say and any sign that their business models are not immune from either competition, the wider economy or regulation could be taken badly, given the lofty long-term growth expectations priced in by those very high multiples of sales and earnings.

Perhaps the biggest challenge though could come from a different – and entirely unexpected - source: inflation. 

Investors warm to growth stocks – and pay high multiples for them – because there is little reliable growth around. If government and central bank stimulus programmes designed to fight the virus do lead to an unexpected bout of inflation, cyclical growth will be just as easy to find as secular growth, if not easier, and it will come at a fraction of the price. 

No-one is really expecting inflation to return, especially when there is a global recession on. But that is what would make its return so shocking and potentially disruptive to what currently looks like a simple story of stock market dominance by a handful of technology stocks. The US Federal Reserve is already switching its policy to a target of average inflation – whereby it will tolerate a period of time where inflation overshoots its 2% target to compensate for a preceding spell when it undershoots that mark – and investors’ inflation expectations are already creeping higher.”

 
Source: FRED – St. Louis Federal Reserve database