By Chris Austin
There is a litany of unanswered questions within the market that investment professionals continue to navigate in order to best position their portfolio for the future. News has been dominated by the election cycle and investors, as they do with any scenario, are taking into consideration the outcome of the elections.
Aside from the pocket of companies that can benefit from the outcome of the election, the Technology sector is one of the most important for investors based on sheer size. The sector accounts for more than 20% of the market cap weight in the S&P500. You think the Tech sector is just like the rest? Think again. The top 5 companies in the sector make up 50% of the market cap weight in the sector, while the top 10 make up roughly 70%. If you are not invested in the top 5 companies, which make up 10% of the weight of the entire S&P500 (AAPL, GOOGL, MSFT, FB, V) that is a portfolio decision in itself. By the way, the three largest companies in the S&P500 are tech companies. This is not the tech sector of the 2000’s – the characteristics of the sector and expansive industry representation are much different today.
Like it or not, Technology rules our everyday lives. With everyone tied to their mobile devices, technology such as paying for services, tracking health, and gathering information are just a few examples of our reliance on Tech. Because of such widespread and mainstream use, it is not surprising that The Tech Sector has outperformed the S&P YTD by more than 5%. It has also outperformed the S&P500 in 2014-2015 and typically has done well in growth oriented environments. So how do we navigate this sector? One should first look to the data to see if there are any conclusions that could help guide their analysis.
Take P/E’s for example, since tech historically has been a growth oriented sector it should be no surprise that P/E levels were at times well over 30, and continue to be around 20 the past 5 years.
Growth and Value Characteristics:
P/E – S&P 500 Technology Sector
Those that follow AFG’s research know the pitfalls of using P/E’s, which is why AFG’s valuation model provides a clearer and a better metric for determining the valuation attractiveness of companies. Keep in mind aggregate data often is effected by outliers but in evaluating the sector through time, 2000 was the worst period to buy into Tech from a valuation perspective, while the financial crisis sell-off provided a once in a lifetime opportunity to buy these companies on the cheap. Currently the average company is trading at a premium to their intrinsic value -20%. However, if we market cap weight the valuation upside/downside of the sector it is trading at a discount of roughly 33%. This just highlights even further the impact of those Mega-Cap Tech companies on the overall sector.
Median % to Target Price – S&P 500 Technology Sector
Much of why there is an aggregate of low valuations for the sector is that expectations are often high for the Tech sector. A company is worth the value of their existing assets plus future cash flows. In the Tech sector there is often a heavy weight priced into the future cash flows because investors are willing to pay a premium for the future growth potential of Tech firms. Unfortunately, these high expectations are hardly ever met. Conversely, investors tend to be much more reluctant to reward larger companies for the actual performance they are delivering. This is in large part because of the frequently changing future cash flow projections of these companies and how far they can fall from grace in a relatively short period of time. AOL, Compaq, Palm, Blackberry, Gateway come to mind.
The Tech sector has delivered roughly 11% revenue growth over the last three years, but that is roughly the same as the growth expectations that are currently priced in. In case you are wondering, the priced in Sales Growth on a market cap weighted basis is very similar. Much like valuation levels, expectations peaked in 2000 but were at their lowest coming out of the Financial Crisis. Expectations dipped again in 2011, providing another buying opportunity and the Tech sector has since outpaced the S&P 500 by roughly 20%.
3 Year Median Implied Sales Growth Expectations – S&P 500 Technology Sector
Competitive Pressures and Volatility:
There tends to be a lot of volatility within Tech because of the disruptive nature of competitor advancements that are quickly adopted by their counterparts. A firm’s Decay period (Competitive Advantage Period) is a concept in which AFG incorporates the effects of competition on valuation levels. This determines the rate at which a company’s economic profitability should be diminished away to zero. The Decay range is anywhere from 7-39 years for any company in AFG’s database, however, the average company in Tech has an average decay period that is generally more aggressive, currently 9 years. Larger companies that are improving Economic Margin levels with low volatility have a much greater competitive advantage and a longer decay period. Currently you can see the decay is on the aggressive side relative to historical levels.
Median Decay Rate – S&P 500 Technology Sector
Current Market Drivers:
Despite the majority of the market being driven by momentum, valuation has played a significant role in the alpha generated YTD in the Tech space. However, much like the rest of the market the highest dividend payers have outperformed the non-dividend payers by over 3%. The spread is much greater with the rest of the S&P 500 but the average yield in the Tech sector is much lower.
What does this data tell us? To begin with, one must put the data in the context of what has made up the sector over time. The Tech sector is much different than it was 20 years ago and much like the technology that drives the sector, it continues to evolve. The companies that are represented in the sector and the expansiveness of the products and services that flow through the rest of the market make it an entirely different beast. Properly evaluating the Tech Sector requires more in depth analysis on a company specific basis. This can be best accomplished using AFG’s Value Expectation modeling interface.
Of the largest market cap companies in each industry within technology, an overwhelming amount look to be attractive using AFG’s multi factor Investment Grade Model vs their smaller competitors. This would bring us to conclude that investing in the larger companies would better positon your portfolio to outperform. To help with the difficulties identifying which of the large Tech companies to buy or avoid, below is a snapshot of the top 10 market cap companies broke down by factor.
If you simply look at valuation attractiveness, MA is the most attractive company while FB is the least attractive.
Biggest Tech companies – AFG Grade breakdown
EM Momentum can often work as a catalyst for valuation, MA is not only attractive from a valuation standpoint but leads the way in terms of EM momentum amount the 10 largest companies.
Over the last six months, Apple has been the best performer of the 10 companies while ORCL has been the worst performer.
If you use a combination of valuation, EM Momentum, and price momentum, the top 5 companies would be the most attractive to invest in with MA and AAPL leading the way.
Performance Analysis of Technology:
AFG uses a multi factor approach that incorporates valuation, quality, and momentum (Company Grade/Investment Grade). This analysis breaks companies into quintile buckets A – F, with A rated companies being the most attractive and F graded companies being the least attractive. By combining these variables our clients have been able to identify the best/worst companies in the Tech sector to invest in. A Investment Grade companies have outperformed the market by 9.3 % and F graded companies have underperformed by -7.9%.
S&P 500 Technology Sector – Investment Grade Performance
For more in depth analysis of the tech sector sign up for a 15-day trial to AFG’s research platform, www.EquityInsights.com. For a free trial click HERE
Craig Burger, CFA
Director of Equity Research
Covington Capital Management – Assets Under Management $2 Billion
AFG Client Since 2007
1). Can you tell us a little about Covington Capital (Who you serve, philosophy?)
Covington is a ten year old independent, employee-owned RIA. Our clients are HNW, Multi-Generational wealth as well Endowments and Foundations but the bulk of our clients are taxable and interested in tax-efficient and risk-efficient investing. We also work hard to coordinate our efforts with our client’s accounting and legal professionals to provide a more consistent investment management solution.
2) You have been an AFG client for over 10 years, what sets AFG apart from other equity research providers?
I was using AFG at my previous firm and helped incorporate it into our investment process here at Covington. Given that we are looking to invest in companies that have the consistent quality metrics in terms of sales growth, margin strength supported by a history of making good capital allocation decisions, the ability to use a tool like AFG to help translate accounting metrics into economic performance metrics is really important. We model every stock that we own in our equity strategies and the Value Expectations and Pro-Forma Builder allows us to build in and test our underlying assumptions as consider what the value drivers are in a particular name. Is pricing driving or hurting margins? How sensitive is the intrinsic value to revenue growth? It is also nice to be able to get a quick snapshot look at EBITDA trends, balance sheet strength, asset growth rates and Management’s track record of past growth and where it came from.
3) Has AFG helped you reach better investment decisions?
I think it has clearly helped, particularly in the Investment Committee dynamic of what constitutes the investment thesis in a particular stock. By focusing the conversation on what a particular set of value drivers may be and then imbedding them in a model it also helps to address the ongoing, and sometimes more difficult question of when to sell something. Has it reached its expected value or has it fallen short and why?
4) How does AFG’s research process and applications help the investment teams save time?
I like that fact that the underlying data is refreshed every week as data becomes available and that when we are looking companies across sectors and across industries we are doing so in a consistent manner, measured to a common metric and is a company generating positive economic margins and thereby creating value for its shareholders and what are the elements driving that value creation (or lack thereof).
5) Any additional comments about AFG?
I am fortunate to have known the Founders of AFG since the early days of the company. I appreciate the rigor of the process and their commitment to continuing to invest and consider ongoing elements of improving the process as well as methods of delivering it those of us who use it.