It’s no secret that technology stocks, led by FAANG,1 have been posting strong positive gains in this bull market. Investors probably hear about the outperformance all the time, which might lead you to reasonably conclude that technology stocks are not cheap.
You’d be right – technology stocks trade at more than a 10% premium to the broader market, which is significantly higher than the post-crisis 4% average.
But in my view, a closer look shows that maybe technology stocks should be trading at a higher premium, given that companies in the tech space are more profitable than the S&P 500 average. The current return-on-equity (ROE) for tech names is over 30%, which is nearly double the average ROE for S&P 500 companies.2 If you look at technology companies through a lens of price-to-cash flow versus the traditional price-to-earnings, the premium starts to make more sense.
Because technology stocks are in high demand and trading at a premium, they also tend to get beat up badly during market pullbacks. The significant market drawdown late last year – which was technically a bear market for a single day – wreaked disproportionate havoc on the FAANG names. The S&P 500 fell around -20%, but Facebook plunged -28.4%, Amazon -36.3%, Apple -37.2%, Netflix -40.2%, and Alphabet -20.2%. With the exception of Alphabet (Google), these declines are more in line with what we’d expect from big bear markets.3
But that’s also precisely why market pullbacks can boost the case for long-term ownership of quality tech stocks.
As I write, the S&P 500 is up approximately +20% for 2019, but technology stocks as measured by the exchange traded fund IYW is up nearly +30%.4 In short: Getting beaten up on the way down can often give long-term investors attractive entry points. If you believe that there is a strong case for secular growth in the technology sector – which I do – then it follows that high-quality technology companies with competitive advantages have an opportunity to potentially deliver strong earnings growth for several years to come. Market pullbacks just make them temporarily cheaper.
Risks to Watch Closely
In a word: regulation. Now more than ever, technology companies are dealing with scrutiny from all angles. The Justice Department is currently conducting an antitrust review of Alphabet’s Google unit as well as Facebook and Amazon. Earlier this month, 48 Attorneys General – led by Texas AG Ken Paxton – announced they were joining together for an antitrust investigation of their own into Google’s practices as they relate to online advertising markets.6 As pressure builds, the forward-looking environment becomes less certain, since regulation could pose a threat to future earnings. At the same time, the right kind of regulation could also potentially benefit new entrants and create entirely new revenue streams into the sector. I’d argue that regulation can create speedbumps for the biggest companies, but that it won’t stop the growth engine overall.
But here’s the real kicker, which I think matters most to investors: any regulatory breakthrough that results in real legislation is likely to take years. 2020 is also an election year, meaning that big ticket legislation that is not passed during the balance of 2019 is not likely to see the light of day in Congress for another couple of years. If anything, I’d expect any regulation targeting the tech sector to be small at first, which I do not believe will impact earnings in a meaningful way.
Bottom Line for Investors
Many readers who have been following my columns for some time know that I don’t advocate for market timing and that I also don’t tend to put too much emphasis on technical analysis. So, it’s important to note that my case for tech stocks during market pullbacks has everything to do with owning high-quality, highly profitable companies that have strong secular growth cases – and trying to buy them cheaply.
Uncertainty surrounding the regulatory environment and the trade skirmish may have some influence over pricing in the near term, but longer term I see technology companies in a position to outperform the broader market not only from a return standpoint, but also from an earnings standpoint.
For investors, my advice is to resist skewing your portfolio’s allocation to favor top-performing asset classes. This late into the economic and business cycle, I believe it is of utmost importance to align your portfolio allocation with your risk tolerance and needs. I am not saying ignore tech, but make sure you are still diversified.