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Podcast: Big Tech: The Road to Underperformance

BMT Chief Investment Officer Jeff Mills cuts through the noise and recent sub-plots in the financial markets to look at Big Tech and what may lie ahead for the Tech sector. In this podcast, Jeff discusses equity valuations, interest rates, inflation, and policy risks related to Tech, a piece of BMT’s overall 2021 Investment Outlook.

Transcript

Introduction:

Welcome to the Bryn Mawr Trust Wealth Management podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jeffrey Mills, chief investment officer at BMT Wealth Management.

Jeff Mills:

Welcome back to another edition of Bryn Mawr Trust’s Investment podcast. I’m Jeff Mills, CIO, and typically at the end of a quarter, especially in, in January or February at the start of a year, I would be doing a podcast that focuses on our investment outlook. And in going through the document that we published earlier in January this year, maybe a little bit of a different approach, just in that we did some webcasts over the past couple of weeks where we did a deep dive into the outlook. I presented along with some leaders from our investment research team here. So I thought what I would do is maybe drill into a more specific area of the outlook rather than get into the outlook as a whole. I think that might be a little bit more interesting, especially for folks who were able to join the webcast and, or read the actual outlook publication.

Jeff Mills:

There’s been a lot going on to distract us from really the fundamentals of the market and what our outlook really is. Look no further than GameStop and AMC and Robinhood and the saga that’s unfolded there over the past couple of weeks. I can certainly tell you that, that, that my mind has been elsewhere at times. The other day I walked home from work and noticed that the car wasn’t in the driveway and I asked my wife where the car was and she reminded me that I drove it to work that morning. So obviously I’ve been I’ve been thinking about a lot of things, the market and all of the other stories that have been going on sort of around the edges. There’s, there’s, there’s been a lot to think about and a lot to consider in, in 2021 even already.

Jeff Mills:

But but with that, let me dive into, you know, one of the main areas of our outlook, which is really this broadening out of market participation, or the move away from large cap mega cap tech, not, not in the sense that that sector is going to crash, but in the sense that perhaps that relative performance dominance, that large cap tech has had for so many years may be coming to an end. And we’ve been really focused on our exposure in mid and small cap and maybe some more cyclical sectors think about, you know, industrials financials those sorts of areas where we think that there’s a relative performance advantage that really has unfolded over the last quarter. And we think it probably continues to unfold as we move through 2021. So let’s focus specifically here on big tech. I think there’s the most interest there.

Jeff Mills:

A lot of these companies, you know, Facebook, Amazon, Apple, Netflix, Google, Microsoft ,Tesla. These are all of the companies that get the most press that people are most focused on. And quite frankly have been the most dominant over the past 10 years. So let’s think about the big Tech’s relative under-performance. And we think that that will wane as we move through 2021. So just to set the stage over the last 10 years technology stocks, they’ve been the undisputed winner. There there’s really no question about it. And just for a little bit of context. So if I take the Russell 1000 Growth Index, a very tech heavy that’s outperformed the Russell 1000 Value Index by over 7% per year, on average, over the last 10 years that’s a huge move over to standard deviations from what will be considered normal. Really the last time we saw that was during the late 1990s during the tech bubble there’s certainly differences today relative to the fundamentals of those companies.

Jeff Mills:

But still that performance gap is extremely wide. And I don’t know that it’s sustainable. We all know that kind of that big performance spread can drive a big spread and valuations, but valuations aren’t necessarily a great timing tool. That said, I feel like any good thesis for talking about an underperforming asset class always starts with that asset class being overvalued. So it’s not that, you know, the Facebooks and Amazons and Apples of the world really other large tech companies included. It’s not that they’re not great businesses. I think they’re, they’re fabulous businesses by most measures. I think you can, you know, we, we put our money where our mouth is relative to that in, in, in that some of those companies are our single largest stock exposures. They just so happened to be our largest underweights relative to the benchmark, just given how concentrated the market has become.

Jeff Mills:

I think the problem is with those companies is that the price is now necessitate a level of future growth that that’ll be very difficult to realize. So these companies are great, the fundamentals are good, but now the price of the stocks just dictate a future growth level that like I said, might be unrealistic even in the most optimistic scenarios. So, you know what, almost 24% of the S&P 500 you know, those top five stocks, which are those, those large stocks, Amazon, Apple, Netflix, Google, et cetera. You know, that, that concentration is now, you know, pretty well known. But that concentration is really a big contributor for the elevated valuations of the broad market. The S&P 500 generally is inflated from a valuation perspective at over 22 and a half times earnings. We talk a little bit about why we think that that can continue in the outlook, but nevertheless, still expensive by historical standards actually in the 94th percentile of all observations dating back to 1985.

Jeff Mills:

But if you remove just seven stocks, so take Fang plus Microsoft and Tesla, that PE ratio drops to 20. So just about two and a half turns from a PE perspective. So still historically expensive. There’s no question about it, but meaningfully less so, I think, especially when you consider that the earnings for a lot of the remaining companies have yet to fully recover from what happened during the pandemic. So you know, I think that that’s an important place to start in, in considering the valuation. And then I think on the earnings front despite some of the unique advantages created by the pandemic last year, Tech’s relative advantage from an earnings growth perspective actually peaked last year as well. So you know, techs, tech earnings growth, we’re growing more rapidly than the rest of the market. That peak last year, it failed to exceed the previous high water mark that relative earnings growth advantage that was set in 2010.

Jeff Mills:

So you have a sector that’s generally more expensive than others and you also have an earnings growth advantage that’s starting to slow down a little bit as well. So I feel like from a fundamental perspective the setup isn’t necessarily great for continued outperformance. And then you get into the idea that tech is particularly exposed to the potential for rising interest rates and the potential for rising inflation. You know, low interest rates, I think in general, they’ve been an enabler for above average valuations, but tech is probably most dependent on rates staying low from a sector perspective. Low interest rates increase the value of a company mathematically. If you look at companies with, with long dated future cash flows like technology, and you do a simple present value calculation, the lower the interest rates are for some of those companies with those long dated future cash flows, where the growth is going to happen further out in the future.

Jeff Mills:

They benefit the most from lower interest rates and, and it increases that present value of those companies. So I think just from that simple perspective that the tech sector is, is most vulnerable to any acceleration in economic growth that we’re going to see this year and any subsequent rise in interest rates we expect. You know, w we talk about it in the outlook in, in sort of great detail, how we think that economic fundamentals are improving. I think what we’ve seen over the past couple of weeks is that the distribution of the vaccine is starting to ramp up as well. So I think you take those things in combination, and although we don’t expect longer-term interest rates to increase dramatically, we do think that the path of least resistance is probably drifting higher rather than moving lower in any significant way.

Jeff Mills:

So again, I think tech is most vulnerable in that scenario. And I think similarly if you have better growth especially in a world where you’ve had money supply grow over 25% year over year, you have all of this stimulus that’s been pumped into the economy. I think inflation is something that we at least have to consider. Again, we don’t think inflation is going to spike in a way that’s unruly in 2021, but we do think the path of least resistance from inflation is higher. And I think that that’s probably another risk to Tech’s dominance. If only for the reason that if inflation expectations start to rise real inflation starts to rise then that likely puts up a pressure on interest rates as well. And I think you can make an argument that, well, you know, unemployment is still elevated and there’s slack that remains in the economy, and that’s absolutely true.

Jeff Mills:

And I think in part that’s what keeps a lid on inflation to some degree, but I think the fiscal stimulus that we’ve seen, whether it’s the past stimulus or the stimulus we’re likely to get in the not too distant future, I think that probably quickly closes the gap in some of these areas of the economy that’s still exists at a time when, like I said, fundamentals are actually naturally improving just due to the vaccine rollout activity returning to normal. So that combination should accelerate a recovery in economic demand and create some upward pressure on prices. I think even if you look at the extreme momentum of the technology bubble the tech sector could not sustain its relative outperformance when interest rates started to move higher. And when inflation started to move higher we’re going to put out a piece that really covers a lot of these points that I’m making right now.

Jeff Mills:

And there’s a chart there that shows a core CPI relative to, to the S&P 500 versus the broad market. And you can see in the late 1990s, early 2000s, when inflation started to pick up, that’s exactly the point where the S and P 500 technology sector started to underperform versus the broad market. So I think we could be in for a similar situation today, if, and when we see interest rates start to rise, inflation, start to creep up as economic fundamentals start to improve. The last thing I’ll say relative to the potential for tech underperformance is simply policy risk. So I think the tech sector appears vulnerable from two different policy perspectives. One would be tax increases and the other would be regulation. I think tax increases maybe more imminent regulations, sort of a slow burn over a multi-year period.

Jeff Mills:

But on the tax side, I was looking at data from Empirical Research Partners. They said that just before the pandemic, the median technology interactive media firm was paying an effective tax rate of about 13%. So that’s more than 5% lower than the median for the rest of the market. So I think it’s a logical to believe that tech’s leadership from a stock performance perspective is disproportionately exposed to a shift in corporate tax policy, which we do think is likely. I think Democrats they want to pass certain spending bills. And I think they’re probably going to need to do so through the budget reconciliation process or the only need to do it with a straight majority of 51 votes in order to do that, there needs to be some spending offsets over the next 10 year period and that’s likely going to happen through higher taxes.

Jeff Mills:

So I do think that that’s more of an imminent risk for the earnings of technology companies. And then on the regulation side, you know, I think as concerns about the power of big tech and the power that they’re able to exert over our daily lives start to grow. I think that increased regulation is very likely, and this at least to me appears to be a bi-partisan opinion where these companies at least need to be looked at. We need to understand what guardrails should be put in place to make sure that these companies are behaving in a way that isn’t detrimental to the general public. There aren’t any anti-trust issues, things of that nature. So even though I think a major shift in regulation in terms of some of these big tech companies, isn’t a, an immediate priority of the Biden administration.

Jeff Mills:

It’s not something that’s going to happen over the next couple of months. I do think that, like I said, an increase in antitrust scrutiny along with just a momentum that’s building for broader oversight of these businesses it, it is a risk and it’s something that’s going to be at least some overhang to these companies over the next number of years. So I think if you take everything I said in combination although we certainly don’t think that the technology sector is going to crash or you would want to remove all exposure from these companies in your portfolio. We do think that the time seems right for tech to relinquish its reign at the top. And for that reason, our positioning looks the way it does. Like I said, we still have large exposures to some of these single stocks, but they are underweight relative to the benchmark.

Jeff Mills:

We do have a higher than benchmark exposures in mid cap and small cap stocks. And certainly in some of the sectors that might be considered more cyclical and more levered to an economic recovery that we think is going to continue to unfold as we move through this year. So I hope that was useful to shine a little bit more of a specific light on, on one of the topics that I think is interesting and really impactful in terms of our overall thesis, in terms of the economy recovering and the market broadening out certainly more so than, than what we saw in 2020. As I said, I would keep an eye out for a piece that, that lays out some of this in, in a little bit more detail. It has a charter to that may be interesting. So I hope you find that useful. And as always, thanks for listening. Bye bye.

Closing:

This has been a production of Bryn Mawr Trust. Copyright 2021. Visit us online at bmt dot com forward slash wealth. The views expressed herein are those of Bryn Mawr Trust as of the date recorded and are subject to change without notice. Guest opinions are their own and may differ from those of Bryn Mawr Trust and its affiliates and subsidiaries. This podcast is for informational purposes only and should not be construed as a recommendation for any product or service. BMT Wealth Management provides products and services through Bryn Mawr Bank Corporation and its various affiliates and subsidiaries, which do not provide legal, tax, or accounting advice. Please consult your legal, tax, or accounting advisors to determine how this information may apply to your own situation. Investments and insurance products are not bank deposits, are not FDIC insured, are not backed by any bank or government guarantee, and may lose value. Past performance is no guarantee of future results. Insurance products not available in all states. Any third party trademarks and products or services related thereto mentioned in this podcast are for discussion purposes only. Third party trademarks mentioned in this podcast are not commercially related to or affiliated in any way with BMT products or services. Third party trademarks mentioned in this podcast are not endorsed by BMT in any way. BMT may have agreements in place with third party trademark owners that would render this trademark disclaimer not relevant.