The investment story of the year is undoubtedly how significantly the big five US tech companies have outperformed the rest of the market. But the trillion-dollar question is: do these businesses still offer value?
It has undoubtedly been a year of two completely different markets. The big five US tech stocks have delivered 35% year to date, compared with the 5% increase in the S&P 500 index. Amazon is up 63%, Apple 43%, Facebook 25%, Microsoft 27% and Google’s parent company, Alphabet, 10%. Together, these companies are now worth nearly $7-trillion and represent more than 20% of the value of the S&P 500 index. While they do not dominate the US index to the same extent as Naspers does the JSE, the market cap of these five stocks is about seven times the value of the entire JSE.
Before the pandemic hit, the services delivered by big tech were already ubiquitous. For instance, 82% of US households are Amazon Prime members, which gives them unlimited free delivery for $119 a year, compared with only 53% of US adults who voted in their 2018 House of Representatives election. Consumer demand for their products and services has taken off because these online giants meet everyone’s basic needs more conveniently and cost-effectively than their competitors, the traditional physical providers of the same services.
The lockdowns, remote working and social distancing required by the pandemic have significantly accelerated the adoption of digital solutions. As an indication of how quickly demand for digital services is growing, Microsoft CEO Satya Nadella said recently that two years of online adoption growth happened in two months.
Have the big five tech stocks any further to go? Anything can happen over the short term. Over the longer term, most of these companies are still an attractive proposition on a risk-adjusted return basis. Thus, we still own Amazon, Facebook, Microsoft and Alphabet in our funds. A core part of the investment rationale behind our continued exposure to these stocks is that on a forward-looking basis they are still valued more attractively than other high-quality contenders. Quality companies include household and personal staples businesses such as Kimberly-Clark or Procter & Gamble, or beverage businesses such as Coca-Cola.
While cloud penetration of IT services has doubled over the past five years, it still only represents 14% of back-end IT spend, which gives it further room to grow
As a group, the 20 best-known businesses in the quality category are still trading at slightly higher valuation levels (forward price-earnings multiple of 27 times) than the big tech stocks we own (25 times adjusted for their large net cash balances) aside from Amazon, the earnings of which are well below our assessment of normal long-term. Supporting the investment case is our expectation that the tech stocks are likely to produce four to six times faster growth than the market and staples over the next three to five years.
As an active, bottom-up investor, we own businesses based on their individual merits. These include whether they have superior business models, their market position is defendable, they can grow their market share, and there are other supportive secular drivers. The potential for growth in the sector remains strong. While cloud penetration of IT services has doubled over the past five years, it still only represents 14% of back-end IT spend, which gives it further room to grow.
E-commerce penetration has increased more than 40% over the same period, but it still only represents 10% of total retail spend. The huge scale of their addressable markets, network effects, high-quality management teams and R&D spend also make it harder for smaller businesses to compete with them.
As with all investments, there are risks. As fundamental investors we are more concerned with the longer-term structural risks that may upend the investment case than short-term volatility. The success of these companies has caused them to attract more regulatory scrutiny, primarily due to competition concerns.
Concerns have also been raised about the fairness of their treatment of employees (pay and working arrangements of Amazon’s warehouse workers), suppliers (Apple’s insistence on a 30% revenue share for in-app purchases) and customers (privacy concerns in the case of Google and Facebook).
China-US trade tensions may also have an impact on the sector, with Apple, which both manufactures and sells devices in China, particularly at risk. These companies may also be expected to pay much higher taxes in future.
To minimise our exposure to the risks, we are selective about where we invest, owning some but not all of these big tech stocks. We also consider higher tax rates and regulatory costs when valuing the businesses. Our funds furthermore have an exposure to the big five that is appropriately sized. At the time of writing, our global equity fund had 11% exposure to big tech, compared with the index weight of 20% in the S&P 500, or the 40% portfolio weighting in a specialist sector index such as the NYSE Fang+, which bizarrely excludes Microsoft. In turn, our recommended multi-asset fund for long-term investors wanting a complete, diversified solution, had exposure of about 7%.
The pandemic has significantly increased risks, which makes attractively priced assets that have the potential to outperform challenging to find. As valuation-driven investors we always try to cut through the noise and find those assets that offer an attractive risk-reward proposition.
While some may think big tech stocks no longer deserve their leading role in the year’s investment story, we don’t believe they are ready to take their final bow. However, we wouldn’t recommend putting all your eggs in one basket.
• Survé is a portfolio manager in Coronation’s developed markets team.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.