Commentary: Investing in markets? Why future gains lie in tech stocks
Despite tech stocks tumbling on Wall Street in recent weeks, OCBC’s Vasu Menon says investors with a good risk appetite would do well to hold onto tech stocks.
SINGAPORE: Investors got a scare recently when tech stocks on Wall Street tumbled sharply.
Over a period of about three weeks starting from Sep 2, the benchmark NASDAQ Composite index fell by about 11 per cent, leading many to wonder if the party is over for tech stocks and if they are poised for more downside.
The big tech titans led the recent declines. Apple fell 18 per cent while Microsoft and Alphabet slipped 12 per cent and 16 per cent respectively.
Recent tech darlings like Salesforce.com fell 13 per cent while Tesla dropped about 33 per cent initially before staging a 29 per cent rebound to regain much lost ground.
REMINDER NOT TO BE COMPLACENT
The tech sell-off is a good reminder to investors not be complacent.
The S&P 500 index had surged to new highs before the recent correction but these gains were driven by a narrow base of stocks, namely the mega-cap tech giants – Facebook, Apple, Amazon, Alphabet and Microsoft – which account for almost 25 per cent of the index based on market capitalisation.
Other growth stocks have joined the party, including Salesforce.com, Tesla Inc and other predominantly tech companies leveraged to secular growth trends, not influenced by short-term cyclical or seasonal factors, like cloud computing, 5G and the like.
TECH SELL-OFF NOT TOTALLY UNEXPECTED
The tech sell-off was not totally unexpected, especially on the heels of a massive rally in August. Despite economic, political and earnings uncertainties, the S&P 500 index soared further, driven by strong investor sentiment.
Factors such as Apple and Tesla’s stock splits had also supercharged the recent tech-driven rally.
Some market consolidation is indeed warranted - healthy even - a reminder as well that the market can also move in another direction. What goes up can as easily come down.
TECH SHOULD BE A CORE LONG-TERM HOLDING
Despite the recent correction in tech stocks, we are not negative on the sector. In fact, we think that it should remain a core-long term holding for those with a good appetite for risk.
From a longer-term perspective, the upside for tech stocks is not over. In fact, it is more likely that the bull is simply taking a much-needed breather.
The longer-term picture remains conducive for risk assets, including tech stocks, on the account of a normalising business environment, a moderate economic recovery and ultra-loose monetary policy.
As such, bouts of volatility can offer investment opportunities to buy incrementally at more favourable price levels.
Nevertheless, given the sharp rally in tech stocks, the recent sell-off may be a signal that investors and traders are getting nervous about the sector at least in the short-term.
Consequently, we could see some funds switching out of tech stocks and into cyclicals and value stocks which have underperformed.
This is not to suggest that investors will or should abandon tech stocks. On the contrary, the sector will remain a strategic component of investors’ portfolios as there are several factors that may drive this optimism in the sector.
First, it is given that technology is poised to drive major and transformational changes in the way individuals and businesses operate in the coming years and decades.
Even when COVID-19 comes to pass, information and communications technology may bring about significant and permanent changes in the way individuals and businesses function.
It has already been a big enabler in keeping people connected during COVID-19 and allowing them to purchase goods and services online despite lockdowns.
Companies which offer the requisite technology or embrace technology to facilitate connectivity and deliver goods and services online to consumers and businesses, stand to benefit.
COVID-19 has clearly given e-commerce a big boost and there may be no turning back as more activities go online.
Companies that offer cybersecurity services also stand to benefit as online activity could pick up sharply after COVID-19.
Second, technology is clearly a multi-year theme and unlike the dotcom bubble that burst in 2000, the tech rally this time around has a much stronger fundamental basis – since tech companies now are backed by real underlying technologies and businesses with good and real growth potential - for those with a strong risk appetite and a long-term investment horizon.
Third the potential for mergers and acquisitions is another factor that could drive tech stocks in the years ahead.
Cash-rich giant tech companies are constantly on the prowl for existing players looking for synergies and growth, especially those with proprietary technology and a strong business proposition.
Google, Amazon, Apple, Facebook and Microsoft have all made a large number of deals so far this year, in what has labelled by some as the fastest pace of acquisitions and strategic investments since 2015.
VALUATION SEEMS HIGH BUT IS NOT EXCESSIVE
On a forward price-to-earnings (PE) basis, the NASDAQ composite index is trading more than three standard deviations above its seven-year historical average.
Typically, when PE valuations are more than one or two standard deviations above the five or seven-year historical average, this is deemed as expensive.
In this respect, NASDAQ’s PE valuations based on next year’s arguably normalised earnings forecast - assuming COVID-19 comes to pass and earnings recover fully from the pandemic-led drawdown - look rather extended after the sizeable price gains in recent months.
But when it comes to valuations, it is important to draw a distinction between the short term and the long term.
Valuations may not seem cheap in the short term, but the tech sector offers significant growth potential in the long term and tech stocks have the potential to be multi-baggers - which are stocks that deliver returns of more than 100 per cent - as we have seen in the past.
For such high growth stocks, valuations tend to be higher to reflect the long term and exceptional growth potential.
One could therefore argue a more accurate way to assess the valuation of high growth stocks like tech stocks would be to look at the PEG ratio, determined by dividing the price-to-earnings (PE) ratio by the earnings per share growth rate (G).
In theory a PEG ratio below one would be favourable while a ratio above one would be unfavourable.
Based on data from Bloomberg, the NASDAQ Composite index’s PE ratio based on estimated earnings in the current year is about 37 times. This may seem high, but the estimated earnings growth of the index is also high at 67 per cent for the current year. This translates to a favourable PEG ratio of less than one.
However, going forward such high PE ratios can only be justified if earnings growth remains high.
Clearly this may not be the case in each year, but over a say five- to ten-year period, the average earnings growth can be high.
Looking ahead, there will be hits and misses in the sector as far as earnings are concerned and that means investors must be ready for sharp volatility, given its diversity.
BE CAREFUL NOT TO OVER-INVEST IN THE TECH SECTOR
For those with the risk appetite, there are good reasons not to give up on tech stocks, but at the same time, do not throw all your eggs into one basket either.
The tech sector has been the darling of stock markets so far this year, but do not ignore non-tech stocks that have underperformed either.
READ: Commentary: How Tencent became world’s most valuable social media company – and then everything changed
History tells us that it is unwise to over-invest in one sector or theme and it is important to have a diversified portfolio to hedge against the uncertainties ahead. So, investors ought to consider a mix of tech and non-tech stocks and even bonds, as well as gold in their portfolios.
The exact mix is something an investor can work out with a financial advisor and it will depend among other things on one’s risk appetite, time horizon and financial objectives.
At the same time, keep some dry powder even though interest rates are very low right now and it may make little sense to hold too much cash. Nevertheless, have some cash on standby to capitalise on the market volatility in the run-up to the US elections in November.
Even after the US elections, volatility in the tech sector can be high as the US slugs it out with China in the tech space for dominance.
Get ready for a choppy ride. Just don’t give up on tech stocks yet – it’s still early days.
Vasu Menon is Executive Director of Investment Strategy at OCBC Bank.