The stock market’s gains this year have taken a lot of people by surprise. But a closer look at the details shows that the performance of just a handful of dominant technology firms, specifically Facebook, Apple, Amazon, Microsoft and Google, is behind much of the broad market’s gains. Since January, these five “FAAMG” stocks have advanced on average, 27% while the broad market has moved ahead closer to 10%.
This price action has many recalling the 1990s technology bubble. From the end of 1998 to the first quarter of 2000, the Nasdaq Composite gained over 191% on investor enthusiasm for the internet and other emerging technologies. Dashed earnings expectations combined with sky-high valuations sent the index down 75% over the next two years. While the shares of many of the most popular firms have recovered and even prospered (Microsoft, and Oracle), many failed to reclaim earlier peak price levels or have gone out of business altogether.
Investors should be careful not to draw too many parallels between the 1990s technology bubble and the price action of today’s technology leaders. Back in 2000, investors were willing to pay inflated prices for companies with little, if any, earnings. At its peak, Cisco was trading at 179 times earnings, Intel was at 126 times and Oracle close to 87. The earnings growth expectations embedded in these valuation levels left investors primed for disappointment.
Valuations in the technology sector today are, in general, not at the extreme levels witnessed earlier. True, expectations for Amazon shares, which trade at over 80 times earnings, appear quite inflated but Apple and Microsoft shares both trade at pretty reasonable levels considering each company’s financial strength, market position and earnings prospects.
What lies behind investor willingness to overpay for growth is the tendency to extrapolate positive earnings trends well into the future. But, interestingly, the same tendency to extrapolate recent history also presents opportunity. Today, investors are assuming that the shares of many “old economy” companies hold little value. Take a look at the chart below. The majority of these firms come from mature industries with lower growth prospects. But this fact alone obscures a number of important positive attributes. Most of these firms enjoy dominant market share and their legacy businesses continue to generate ample cash flow. In some cases, available cash is being used to invest in new ventures – think Big Data at IBM or e-commerce at Walmart. Other firms, under pressure, are returning capital to shareholders in the form of share buybacks or dividend increases. Finally, the shares are cheap. Many are sitting at, or close to, their 52-week lows and trade at P/E levels that are one-third to one-half less than the average stock today.
Not all of these caterpillars will turn into butterflies. A cheap share price is often just a good indicator of a company with limited prospects. So how to identify future winners? First, strong end market opportunities are critical. For example, Microsoft is moving into cloud based services while nurturing its more mature software operations. Second, ample financial resources are a big help. Firms with limited debt levels and ample cash flow can invest the time and money required to explore new ventures. Finally, and most importantly, is superior management. Navigating change is no small task; it requires keen insights into existing and future businesses, leadership skills and tenacity. This is particularly true today when activist investors put company management on an increasingly short leash. But history is full of such success stories. GE has remade itself multiple times and Corning, once a manufacturer of household goods, now leads the world in glass technology. We would rather bet on the shares of companies where expectations are low and opportunity is high. This is where we are focusing our efforts in today’s high priced market.