Technology companies not over-valued – Gerrit SmitPublished on 20 Nov 2020
Strong earnings growth and cash flows bode well for tech sector
The fear with stock market bubbles – like all bubbles – is that they might burst unexpectedly. Critically, though, they only pose material risk if there is neither earnings growth nor cash flow to support them. This is not the case for today’s technology sector; there is no bubble. Indeed, in terms of growth, there is currently more reason to be confident about technology companies than there is about many ‘staples’.
Stonehage Fleming Investment Management expects 13-18% earnings growth in the tech sector over the next three years. That is more than double what you could expect under a constructive scenario for the ‘market’ as a whole. If you divide that projected growth into the earnings multiple, you get a price/earnings-to-growth, or ‘PEG’ ratio of approximately 3.1. If you calculate the same ratio for typical companies of the calibre to meet our stringent quality criteria for GBI, that number is 4.1. We therefore believe that the technology leaders may be actually around a quarter less expensive in terms of growth expectations than the valuation of the highest quality universe of companies - a concept many struggle to make peace with.
Furthermore, there are very strong arguments for technology’s continued structural growth story. Ecommerce penetration in the US has doubled from where it was at the end of last year, which has huge structural implications – positive and negative – for many businesses around the world. It is a trend set to continue with payment companies also likely to do particularly well.
Possibly most obviously, given the pandemic, the digitisation of healthcare is another sector in which investors can expect to see strong continued growth. Streaming services, too, will thrive as people continue to adopt new ways of consuming media in their droves.
Nevertheless, regulation of technology companies is a possible blot on the sector’s landscape. What we are seeing so far is legal action taken against companies employing tactics deemed to be anticompetitive. Take Google, a company with nearly 90% market share, thanks in part to an almost exclusive arrangement with Apple whereby it gets to be the search engine of choice on their tablets and phones. It seems likely that regulators will consider taking steps to address this kind of agreement.
Having said that, Google is unlikely to lose out much in that scenario. It is hard to imagine another search engine that people would turn to in the same numbers.
And what of regulators unbundling some of the world’s technology behemoths into smaller entities, albeit currently an outlying possibility? In the case of Amazon or Alphabet, the sums of those potentially split parts are likely to be worth more than the entire companies’ current valuations, so this doesn’t appear to give too much cause for concern either.
Earnings and cash flow from the technology market leaders are the very generators and employment creators of our economy. As they continue to support the good health of both businesses and share prices around the world, they look set to do so for some time to come.
Gerrit Smit is Head of Equity Management. He manages the Stonehage Fleming Global Best Ideas Equity Fund.
Disclaimer: This article has been prepared for information only. The opinions and views expressed on any third party are for information purposes only, and are subject to change without notice. It is not intended as promotional material, an offer to sell nor a solicitation to buy investments or services. We do not intend for this information to constitute advice or investment research and it should not be relied on as such to enter into a transaction or for any investment decision.
Whilst every effort is made to ensure that the information provided is accurate and up to date, some of the information may be rendered inaccurate in the future due to any changes.
© Copyright Stonehage Fleming 2020. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission.
It has been approved for issue by Stonehage Fleming Investment Management Limited, a company authorised and regulated in the UK by the Financial Conduct Authority and in South Africa by the Financial Sector Conduct Authority. It has also been approved for issue by Stonehage Fleming SA which is regulated in Switzerland by the Association Romande Des Intermédiaires Financiers and Stonehage Fleming Trust Holdings (Jersey) Limited which is regulated by the Jersey Financial Services Commission.