Rational Optimism About Big Tech

After a multi-year stretch of almost uninterrupted outperformance, some investors are growing worried the Technology sector is partying like it’s 1999. Is this the second Tech bubble in recent memory, they wonder? As evidence, many point to lofty valuations, noting a few are at late 1990s-ish levels. But in my view, the evidence supporting Tech bubble 2.0 concerns misses the mark, as it relies mostly on valuations. Valuations just aren’t predictive and ignore important context.

As we’ve previously written (here, here and here), valuations alone tell you very little about returns over the next 12 or even 24 months. Cheap stocks can get cheaper; pricey ones can get pricier. As a result, you simply can’t judge a bubble on valuations alone. Consider: Was the Energy sector in a bubble in 2015 and early 2016? Those who remember the time—when Energy stocks were swooning and sentiment was in the tank—would surely say no. But if you define bubbles by super-high P/Es alone, you miss that context. You see, P/Es were soaring as Energy companies’ earnings (P/Es’ denominator) plummeted due to falling oil prices. Another example: Was the S&P 500 frothy in early 2009? That may seem ridiculous, but valuations were stratospheric by many measures due to the 2008 financial crisis’s earnings erosion. Widely used valuation metrics are just one measure that may describe sentiment. But you also have to dig in and actually analyze the components. Then, put them in broader context.

When put into such a broader context, even the basic claim of extremely high Tech valuations similar to the late 1990’s Tech bubble appears flawed. Select valuations such as Tech price-to-sales ratios may be elevated relative to history. But is that necessarily irrational? Consider: Tech margins are generating higher earnings growth for investors. Actually, Tech boasts the highest gross profit margins of all sectors (Exhibit 1)—a key differentiator from Tech in the late 1990s, when investors were clamoring for unprofitable firms with little more than a vague business plan. In the last 20 years, the net profit margin of the S&P 500 Technology sector has more than doubled, as high-profit margin Internet and software firms have rapidly surpassed lower-margin hardware firms as the dominant Tech industry group. Today, the sector is comprised of some of the most profitable companies on the planet. It stands to reason investors are willing to pay up for this—particularly in the late stages of a bull market, where rising valuations are perfectly normal and reasonable!

Exhibit 1: Tech Has the Highest Gross Profit Margins of All Sectors

Source: FactSet, as of 12/1/2017. MSCI World Index and sector last 12 months average gross profit margins, 12/30/2016 – 11/30/2017. Financials excluded due to banks’ business models, as banks don’t technically have gross margins. Net interest margins are analogous but not comparable.

Still think Tech is frothy? Consider other valuations beyond price to sales—forward P/E, price to cash flow, or enterprise value over EBITDA. While many analysts focus on price to sales for being at June 1999’s levels, most Tech valuations simply aren’t near bubble territory.

Exhibit 2: S&P 500 Tech’s Price-to-Sales Ratio Is Near 1999 Levels …

Source: FactSet, as of 12/1/2017. S&P 500 Tech sector price-to-sales ratio and current level, 9/30/1997 – 11/30/2017.

Exhibit 3: But Price to Cash Flow Isn’t

Source: FactSet, as of 12/1/2017.  S&P 500 Tech sector price-to-cash flow, 9/30/1997 – 11/30/2017.

Exhibit 4: Neither Are 12-Month Forward P/Es

Source: FactSet, as of 12/1/2017. S&P 500 Tech forward 12-month price-to-earnings ratio, 9/30/1997 – 11/30/2017.

Finally, investors caution the Technology sector is a rapidly growing share of the overall market—over 20% of the S&P 500’s market capitalization, for example. True! But so are Tech earnings! (Exhibit 5) Contrast this to the unjustified disconnect between euphoric prices and deteriorating fundamentals in the dot-com era, when profit-starved firms swelled to nearly 35% of S&P 500 market cap at the peak.

Figure 5: Info Tech Earnings and Market Cap as a Percentage of the S&P 500’s
  
Source: FactSet, as of 11/30/2017. S&P 500 and S&P 500 Information Technology sector market value and trailing 12-month net income, 3/31/1995 – 9/30/2017.

Today, Tech bubble fears abound, yet most hallmark bubble signs are absent. Margin debt isn’t spiking. There isn’t a sea of sloppy IPOs finding solid demand. Parabolic sector performance and market caps are absent. Not many stock tips from your Uber driver nor mid-life career changes as a Tech stock day trader (a small smattering in bitcoin, maybe, but that’s a topic for another day). Not much Thanksgiving family Tech talk and nary an envious stare at your friend’s brokerage account returns. Home equity lines and cash advances to buy high flying tech stocks? Not so much. When you weigh the broader reality, this isn’t a very similar backdrop to 1999 at all.