The issue of how to value members of the tech sector is receiving renewed attention. Many indexes are on track to set new records that would establish the longest-running bull market in the nation’s history.
Given the unprecedented rise in tech stocks, some fund managers have expressed concern that application of traditional valuation techniques indicate some companies in the group are overvalued. The view of these managers would seem to be correct if one weighs a number of fundamental factors against current astronomical stock prices and, for some, price-earnings ratios that far exceed the average multiple for the S&P 500. For these investment managers, it makes little sense to continue accruing positions in Amazon (AMZN, Financial), which has a price-earnings ratio of 150 and a price tag of $1,962 per share.
Other portfolio managers, however, believe that the phenomenal rise of the FANG group, as well as other select technology stocks, has ushered in a brave new world of valuation techniques. These fund managers are of the view that traditional valuation techniques, which emphasize analysis of fundamental metrics, such as price-earnings ratios, dividend payout, average earnings growth over a 10-year period, etc., are outmoded in the 21st century era of the tech Goliaths.
These fund managers believe that for tech stocks, historic metrics, such as price-earnings ratios, tend to overstate risks.
This school of thought contends that investors should look beyond price-earnings multiples and apply a broader gauge of a tech company’s financial and strategic business progress. The determinative factor for a rational valuation based on the long term is what will the company’s business look like when it matures and not its current price-earnings ratio.
Advocates of this approach claim that for those who invest in tech stocks on a long-term basis, scrutinizing valuation risk overlooks the future value to a company of its current spending on investments to achieve market dominance in sectors where they enjoy prominence. Examples would include Netflix's (NFLX, Financial) huge investments in producing original content to assure continued growth of its subscriber base.
Adherents of this methodology have some factual basis to support their view. According to Goldman Sachs, an analysis of 40 years of data reveals that the current valuation of the average stock in the S&P 500 is now in the 97th percentile of historical levels. Although this figure is down from the 99th percentile achieved last year, based on these figures, one can conclude that the entire market is overvalued and not just the tech sector.
Regardless, a number of factors militate against the argument that tech stocks in particular are not currently overvalued. The unheralded rise in tech stocks over the last 10 years occurred in an unprecedented environment of near zero-interest rates. This had the effect of inverting the traditional bond-equity relationship, which skewed returns heavily in favor of the stock market.
Secondly, just because some of the defensive sectors, like consumer staples, are selling at prices some consider overvalued, this determination must be made on a relative basis. Amazon, trading with a price-earnings ratio of 150, is a far cry from Colgate-Palmolive's (CL, Financial) price-earnings ratio of 26.8.
There is statistical evidence that supports this view. According to Credit Suisse, an examination of data going back to 1964 demonstrates that higher price-earnings multiples have tended to be followed by weaker returns over 10-year periods in the market.
Many of those who argue that traditional valuation methodologies should be abandoned in the era of the tech titans are too young to remember anything but a roaring bull market. The professional experience of many of these investment managers has been limited to a period during which the market trajectory was in one direction only and interest rates remained low for a prolonged period.
These fund managers seem to be of the opinion that the current investment climate is the new normal.
It is anything but.
Disclosure: I have no positions in any of the securities referenced in this article.
