E-Digests

E-Digest: July 9, 2019 – Can Tech Sector Trees Grow to the Sky?

By July 10, 2019 No Comments

When things are going great, it is easy to let go of critical thinking and embrace a wonderful outcome. However, to paraphrase Plato, in our work, “the unexamined return” can sometimes be an unexamined risk. The data point we are thinking about regards the 30% year-to-date result in the Tech sector of the S&P 500 Index.

Now, if you are thinking that it is unremarkable to question the sustainability of a 30% return in six months, let us be the first to tell you that you have no future as a Wall Street sell side analyst. The herd is euphoric about Tech and even a modicum of skepticism is impossible to find. But beyond just the group think problem, we want to share our take.

  • We are for Technology investing. Our questions are not about the sector per se. The issue is the alignment of business value and stock market quote. Our discipline screens for metrics including Return on Capital, profit growth, great balance sheets and free cash flow generation, and the Tech sector offers more high-quality opportunities to invest in these meaningful characteristics than other sectors.
  • We are always interested in what is sustainable and what might not be sustainable. On this point the data takes us to two measurements: earnings growth and valuation.

Valuation: In round numbers, for the 70 businesses that make up the Tech sector of the S&P 500 Index, approximately 7% of the year-to-date result has been derived from earnings expansion, and about 93% of the return has been driven by valuation expansion. We believe that earnings driven appreciation is much more sustainable than valuation expansion.

Within the S&P 500 Index Tech sector, the ten most expensive PE multiples average 57 X 19e and averaged a 31% return year-to-date.

Earnings Growth: Earnings in this sector are estimated to grow 6% in 2019 over 2018’s results. That kind of growth hardly associates with 30% returns in six months. The 2019e to 2021e projected earnings growth is about 15% annually. When the rationale for valuation expansion stretches out three years (or more) and simultaneously happens in the 11th year of economic expansion, you are getting close to “priced for perfection.” The trouble with being priced for perfection is that it is unsustainable and higher risk.

Per our first point, we are happily invested in the Tech sector. Using our Large-Cap portfolio as an example, we believe our Tech companies accurately represent our Quality at a Reasonable Price narrative. The 2018-2019 estimated average earnings growth is 12%, the average PE is 22X 19e and 19.7 X 20e, Net Debt averages 9.1% and Net Margins average 26.3%.* This cross section of metrics helps us to focus on more sustainable, operating metrics.

Summary
Never confuse brains with a sector rally. Do not extrapolate from a hot six months to “its different this time”. Be discriminating about quality, profits and valuation. Get your share of the good businesses in the Tech sector but think critically about what is sustainable. Remember that the Tech spree in 1999 (NASDAQ 100 +85.6%) was followed by a Tech crash (-67% over the next three years). With this reminder, we reiterate the importance of staying engaged in critical thinking.

 

*S&P Capital IQ 7/9/2019
All data sourced from www.1stock1.com/1stock1_142.htm as of 7/9/2019