Until recently, technology stocks seemed unstoppable. Giants such as Apple and Microsoft, as well as technology-driven consumer firms such as Amazon and Alibaba Group, continue to do well through the COVID-19 pandemic.
Meanwhile, an emerging group of resilient, innovative leaders, ranging from cloud-based service providers and fintech to ecommerce enablers, also showed solid growth, fueled by rapid business and consumer changes brought by the pandemic.
Even with the recent pullback, the tech-heavy Nasdaq Composite index remains at historic highs, surging 21.8% this year through 11 September, while the MSCI World Technology index is up 23.2% for the period.
When compared to the more muted rebounds of the S&P 500 and MSCI World indices, it is clear that investors remain optimistic about the outlook for tech stocks.
Steady gains have pushed up valuations of global technology stocks, which now trade at a price/forward earnings valuation of 24.4x, a 35% premium to the MSCI World Index. Is the gap warranted or based more on irrational animal spirits?
In these unprecedented times, we think some high prices are justified, especially for companies with sustainable growth drivers.
Investors just need to get past a few myths to find the opportunities.
Myth 1: All tech is overpriced
Technology is not a homogenous sector, and not all tech companies are overpriced. In fact, despite recent selloffs, the sector's valuation premium still hovers near its historical average.
At the market's peak in March 2000, the MSCI World's technology and communication services sectors combined accounted for 35% of market cap and less than 18% of the earnings.
But today, the two sectors represent 30% of market cap yet almost 25% of all earnings.
The reason? In an ever more web-connected world, tech companies increasingly enjoy the positive benefit of the network effect, allowing them to take advantage of scale and generate higher incremental margins.
Myth 2: High valuation = high risk
Is it riskier to pay more for a stock? Not necessarily, especially when the reasons and perceptions behind high valuations can be so different.
Tech companies with secular growth drivers, for instance, are perceived to have greater predictable earnings growth versus companies with cyclical drivers, which are more dependent on macroeconomic forces hurt by the pandemic, and therefore considered much riskier.
In the market's current earnings season, information technology companies are among very few reporting year-over-year revenue growthandearnings growth.
Tech companies also fared much better than expectations. Some 74% of IT companies in the MSCI World reported higher revenue expectations and 78% reported upside surprises to earnings, compared to just 51% and 56%, respectively, for the market overall.
In our view, higher valuations reflect the low risk tolerance of the broad investor base. Today, technology companies trade at similar valuations to consumer staples, while offering better growth characteristics.
For instance, shares of bricks-and-mortar retailers and technology companies that provide on-site IT services and equipment may look cheap but could face further declines if the pandemic persists and headwinds intensify.
The low interest-rate environment also fuels tech's growth prospects. High-growth companies tend to have greater income streams coming from future revenue and earnings.
So, when rates remain low, income streams benefit from lower discount rates, helping to boost stock prices.