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Over the past year financial headlines have been dominated by the continued rise in the value of the tech sector stalwarts. Comparisons have been made between the NIFTY 50, which represented the fastest growing companies of the late 1960s, and the FAAMG (Facebook, Apple, Amazon, Microsoft, Google) stocks, which have continued on an upward trajectory throughout this cycle.
This article is from our latest edition of MarketWatch, an in-depth report focusing on the Psychology of Investing.
US technology has been the best performing sector globally year to date, rallying an impressive 27% in dollar terms (14% in euro terms), and the outperformance has primarily been driven by the strong growth in the FAAMG stocks. The technology sector makes up the largest component of the S&P 500, having grown to over $5 trillion over the past number of years and surpassing its tech bubble peak.
This strong performance is starting to worry some investors. But, in our view these concerns can be eased for a number of reasons:
Although certain stocks - such as Amazon which is currently trading at 88 times this year’s earnings - are definitely trading on extended valuations, the tech sector has an average forward P/E (price-to-earnings) of 18.3x, compared to 17.8x for the market. The sector generally tends to trade at a premium to the market but valuations currently remain in line with robust fundamentals.
The sector is expected to generate 10-14% earnings growth over the next two years based on bottom-up forecasts. Strong earnings growth for the sector is a theme that we have seen over the past number of years as it has continued to grow at a greater rate than the market.
The largest technology players are also sitting on an abundance of cash, which is thought to be around 8 times that held during the technology bubble. So these companies have the flexibility to make strategic moves and create inorganic growth opportunities. This cash pile means that they will be somewhat immune to any increase in the cost of capital as US interest rates continue to rise. This also explains why there has been lower volatility in the higher growth technology players than in previous cycles.
Many have compared the growth in the value of FAAMG stocks to the irrational exuberance seen during the technology, media and telecoms (TMT) bubble. The price appreciation in the global tech sector has also drawn parallels with the meteoric rise of NASDAQ during the late 90s and early 00s. These fears seem unfounded as valuations are not as stretched. The five largest stocks during the tech bubble traded on 60x compared to 23x for the FAAMG stocks.
Given its meteoric rise, the tech sector may pause for breath after the strong rally over the past 12 months, but it is clear that there are a number of factors that should help support the tech sector over the coming years. Mobile technology is now part of most people’s daily lives and this should continue as we see growth in internet usage in emerging markets over the coming years. Innovation will continue to drive the sector and most of the large players have diverse revenue streams from a growing portfolios of products.
Figure 1: Famous five continue to drive rally
*FAAMG: Facebook, Amazon, Apple, Microsoft & Google Market Cap weighted