29 Apr 2018
It is now three years since we were overweight the IT sector and almost two years since we had more than 5% exposure in the Invesco Perpetual Global Opportunities Fund. The sector has outperformed the broader market by 87% since the start of 2013 (see Figure 1) and as such has provided a material headwind to our relative returns, particularly in the last two years when our exposure has been particularly low.
Figure 1: MSCI AC World index sector returns: 1 January 2013 to 19 April 2018
Source: Bloomberg, as at 20 April 2018. Past performance is not a guide to future returns.
As investors we think it’s important to remain as objective as possible. To us it’s understandable why the sector has held much appeal to investors. Many of the ‘Big Tech’ companies generate strong organic growth, good cash flow and have very strong balance sheets. They have also successfully challenged a variety of incumbent businesses by bringing a new, innovative approach without carrying the legacy costs that ‘old world’ industries carry.
This has been a potent combination. It’s only in the last couple of months that we’ve begun to hear any discordance with this view, largely stemming from Facebook’s data breaches. Here we outline why we have been more hesitant about owning Big Tech stocks in recent times and offer some perspective on the outlook from here.
We don’t set out to avoid any given sector - rather we are focused on identifying stock-specific valuation anomalies. Simply put we are looking for fundamentally sound businesses when they are being offered at appealing valuations. This focus on valuation often leads us to more contrarian areas of the market; hunting in the areas that others have shunned.
Back in May 2014 we had almost 20% of the portfolio in technology stocks, with holdings in Google, Microsoft and Baidu, amongst others. At that time we felt that there was contention in these share prices, which were reflected in valuations. For Google the market was worried about the transition of Google users’ from desktop to mobile. Eventually Google used the transition to their advantage but at that time there was much doubt.
Similarly, many investors worried about potential disruption to Microsoft’s dominant position in the enterprise segment. This uncertainty provided us with an opportunity to own fundamentally strong businesses at appealing valuations and that view was strongly reflected in the portfolio.
Central to our investment philosophy is a belief that valuation is the critical determinant of investment outcome. That’s why we spend a great deal of time looking for fundamentally excellent businesses when they are clouded by uncertainty.
If we can identify sound businesses when they are out of favour it often provides us with an opportunity to pay a discounted price. We think this gives us better odds of achieving a good result for our clients; critically it gives us a better chance of preserving capital. This is why we aim to maintain a strong discipline around the price we pay for (and hold) a stock.
The performance of ‘Big Tech’ has gone much further than we expected. Technology and e-commerce now accounts for almost a quarter of US stock market earnings (see Figure 2). Remarkably there are currently just five sells out of 250 FAAMG recommendations.
The Big Tech stocks are highly prized and this sentiment is reflected in relatively rich valuations. In our view this represents a risk. When stocks are priced for perfection, any negative surprise could have significant implications.
Figure 2: S&P 500 sectoral dominance - 12 months forward US EPS by sector
Source: BofA Merrill Lynch Global Investment Strategy. I/B/E/S.
Herb Stein, economist
Over the last month or two we have witnessed modest retracements in some of the tech stocks. At present it looks like a small blip on their longer-term performance chart. We don’t know what the future holds but we do worry that current valuations offer investors little protection in the event that life gets more difficult for these businesses.
We believe the future for many of these businesses is more uncertain than most investors anticipate. The recent Facebook experience might mean that regulation of social media becomes more prominent and the miss-use of personal data more heavily penalised. If we think back to the banking sector post financial crisis or tobacco companies in the late ‘90s, the market has tended to de-rate businesses when the regulatory outlook is uncertain.
At present this industry appears very lightly regulated in the context of its economic and political importance (see Figure 3). There are other potential risks too. This industry currently pays very low tax, something that governments look increasingly motivated to resolve. Perhaps more fundamental is that risk that consumers vote with their feet.
Figure 3: US federal regulations by sector
Source: BofA Merrill Lynch Global Investment Strategy, McLaughlin & Sherouse (2017).
Many of the tech companies we have talked about have enviable qualities that we look for in an investment. However, we feel that the market has priced these ‘qualities’ in. We remain disciplined in our approach, trying to identify companies where their intrinsic worth has not been reflected in share prices. We will try to remain pragmatic and assess stocks in a dispassionate way. It might be that uncertainty relating to the outlook for the Big Tech companies gives us an opportunity to buy them once again. For now we see better uses for our clients’ capital elsewhere.
This post originally appeared on the Invesco Perpetual site.
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