The Investment Case for Speed
Twenty years ago, Bill Clinton was president, Tony Blair and Vladimir Putin were new leaders and tweeting was something only birds would do. That was when technology stocks, as measured by the S&P 500 tech index, last traded at their current levels. Last week, the US technology sector surged past its dotcom bubble peak for the first time before retreating somewhat. Investor demand sent shares of companies including Facebook, Microsoft and Oracle into virgin territory. The S&P 500 Information technology index rose for the ninth consecutive day on Wednesday closing at 992,29. That compares with the previous record at 988,49 which was hit on March 27, 2000.
Plenty has changed in the subsequent 17 years. For investors gauging the current run in technology shares, there is one important difference. It is the rapid earnings growth for the sector given the tepid performance of the broader US economy. In 2000 Cisco, Microsoft, Intel, Oracle and IBM were the technology giants dominated investor portfolios. While Microsoft remains, it has been usurped by Apple and Alphabet and joined by Facebook and Visa. Information technology has surpassed any other sector in the S&P 500 this year. It has gained almost 23%, compared with the broader market´s 10% advance.
Technology shares have also benefitted from discord in Washington, with investors skeptical that meaningful tax reform and infrastructure spending can be accomplished this year, they have purchased the shares of companies that have a record of increasing sales and profits. Investors started the year with too much enthusiasm for the “Trump trade”, the idea of owning stocks that might benefit from the new president’s policies. Companies with high tax bills, and those exposed to infrastructure spending, were two examples. As hopes for action from the new administration faded, enthusiasm for tech stocks surged as this industry can generate profits growth regardless of the economic outlook. Tech companies in the S&P 500 are likely to record double-digit year-on-year profits growth in the second quarter.
Many fund managers worry that the money chasing technology shares has reached a tipping point There is nothing like the same stock market euphoria as there was at the turn of the century. Few people are trying to day-trade their way to riches or setting up a dotcom franchise to sell cat food. Tech stocks are not as much of an outlier as they were in 2000, when many investors abandoned “old economy” companies in retailing and heavy industry. Technology companies are expected to generate more than 25% of the S&Ps 500 earnings in the fourth quarter this year. This compares with 15% at the index’ peak in 2000. At that time tech stocks accounted for more than a third of the index. Today that figure has fallen to less than 23%.
Earnings expansion on that scale means that few investors can afford to ignore tech stocks. Since 2009 the industry has been the most favored by global fund managers for 80% of the time, according to a regular survey by Bank of America Merrill Lynch. The latest survey reflected fears that the enthusiasm may have gone too far: 38% of managers thought that betting on tech stocks was the “most crowded trade”; a net 9% had cut their exposure in the previous month.
So, history isn’t repeating itself exactly. But there is still plenty that can go wrong. The overall market is on a cyclically adjusted price-earnings ratio of 30—a level surpassed only in 1929 and the late 1990s. If the Federal Reserve tightens policy too aggressively, or the American economy slips into recession (or both), tech investors will get that sinking feeling again.
Twenty years ago, when the internet was in its infancy, some market pundit came up with the TMT acronym to label this “new economy” investment theme. Technology, media and telecommunications captured the gamut of users interconnected at the speed of light. One reason the first tech bubble deflated at the beginning of the last decade was that telecoms operators could not provide the speeds necessary to support the promise of streaming and other dotcom dreams. Excess capacity appeared and profits eventually fell well short of expectations.
Later in the decade these operators were valued for their utility-like cash flows. Since the global financial crisis, technology companies have exploded in value. Technology has roughly provided a 300% return since early 2009, with media a bit further back. Telecoms, though, have trailed by a long way, not even doubling. This looks odd.
Where would Facebook be if data download speeds had remained at 2011 levels? US median download speeds quadrupled to 40 megabits per second by September 2015, according to the Federal Communications Commission. Even the older tech names, such as Apple and Microsoft, have soared by more than a quarter in the past year. Meanwhile telecoms such as Verizon, BT Group and Telstra are all down by double digits. Investors do not put high values on the infrastructure over which all the data travels. Telecoms operators, which often control the backbone of their local broadband networks, mostly trade at enterprise values of about six times their earnings before interest, tax, depreciation and amortization. While no one expects to see the valuations of telecoms operators roaring back soon to their highs of the early millennium, the infrastructure of the internet deserves a higher rating.
( Graph Source: The Financial Times)