From Jeffrey D. Mills
Chief Investment Officer
Over the last ten years, technology stocks have been the undisputed winner. Whether it’s Apple, Amazon, Microsoft, or any of the mega-cap tech names, investors likely have a bad case of buyer’s remorse holding just about anything else. For context, the tech-heavy Russell 1000 Growth index outperformed the Russell 1000 Value index by about 7% per year on average over the last ten years. This is a 2-standard deviation spread, last seen during the late 1990s. In our opinion, tech’s reign of relative dominance has come to an end…at least for now.
Valuation
Any good thesis for an underperforming asset always starts with it being overvalued. It’s not that Facebook, Amazon, Apple, Netflix, and Google (FAANG) and other large tech companies aren’t great businesses. On the contrary, they are fabulous businesses by most measures. In fact, a number of these stocks remain our largest single stock exposures…they just happen to also be our largest underweights relative to the benchmark. The problem is that current prices necessitate a level of future growth that will be very difficult to realize. At almost 24% of the S&P 500, the concentration of the largest 5 stocks is now well-known, and is a significant contributor to the elevated valuation of the broad market. The S&P 500 is generally inflated from a valuation perspective at 22.5x earnings over the next 12 months (94th percentile of all observations dating back to 1985). Removing just seven stocks (FAANG plus Microsoft and Tesla) drops the forward P/E to 20x. Historically expensive, but meaningfully less so, especially considering that the earnings of many of the remaining companies have yet to recover. Despite the unique advantages created by the pandemic, tech’s relative advantage from an earnings growth perspective peaked in 2020 as well – failing to exceed the previous highwater mark set in 2010.
Interest Rates and Inflation
Low interest rates have been a key enabler of above average valuations, but tech is most dependent on rates staying low. Low interest rates increase the value of companies with long-dated future cash flows (many tech companies) via a simple present value calculation. The technology sector is, therefore, most vulnerable to accelerating economic growth and rising interest rates.
Similarly, a recovery in inflation is another risk to tech’s dominance. Although unemployment is still elevated and economic slack remains, fiscal stimulus (past and future) should quickly close the gap at a time when fundamentals are naturally improving amid the vaccine rollout. This should accelerate a recovery in demand, creating upward pressure on prices. Even during the extreme momentum of the Technology Bubble, the tech sector could not sustain its relative outperformance amid higher rates and inflation (Chart below).
Tech Bubble: Relative Tech Sector Performance vs. Inflation
Finally, the tech sector appears vulnerable from two policy perspectives – tax increases and regulation.
Taxes: According to data from Empirical Research Partners, just before the pandemic the median technology and interactive media firm was paying an effective tax rate of about 13%, more than 5% lower than the median for the rest of the market. Therefore, it is logical to believe that tech’s leadership is disproportionally exposed to a shift in corporate tax policy.
Regulation: As concerns about the power of Big Tech continue to grow, we think that increased regulation is very likely. Although a major shift in the regulatory backdrop for these companies is unlikely in the very near term, an increase in anti-trust scrutiny along with momentum building for broader oversight, regulatory risk is certainly increasing.
Taken in combination, the time seems right for tech to relinquish its reign at the top.
