Can technology stocks continue to outperform the market?
In the past decade, there has been one sector that has clearly outperformed the market — technology. Much of that record-breaking performance has been witnessed in the past two years, and most importantly, the 2020 market recovery.
Let’s look at some of the winners:
- Facebook: up 50% in 2020
- Amazon: up 99% in 2020
- Apple: up 107% in 2020
- Netflix: up 96% in 2020
- Alphabet: up 29% in 2020
- Square: up 182% in 2020
- Nvidia: up 131% in 2020
Now that’s called a staggering performance!
We can’t help but ask ourselves — what’s the cause of this?
One of the main reasons behind the rally is the massive switch to momentum-based strategies. As we previously explored — the constant influx of cash into passive ETFs is driving up the prices. Since the big tech companies are some of the biggest constituents in an index, they stand to benefit the most from the current structural market shift.
While tech stocks have certainly been the star of the show in the past few years, when we look back, their long-term performance is not that impressive. We’ve been somewhat distracted by the tech-only mania, but we shouldn’t forget that the S&P 500 delivered a higher return than the NASDAQ in the period 1999 to 2020. There are a few other things to consider before going all-in on $QQQ call options.
Valuation
If we look at some of the big tech names, we’ll find that the multiples there are nothing short of ridiculous.
Let’s take Nvidia, for example — at the moment, it has a PE ratio of 99. It’s trading at almost 100 times the past 12 months’ earnings!
Amazon is in an even more interesting place — PE of 130 and EV to EBITDA of 39.
While we are not at 2000 levels yet, we need to see a lot of sustained earnings growth in order to justify these valuations.
Now that could prove to be a bit harder than expected.
Saturation
The issue that we see with these expectations is that a ton of growth is priced into companies that are already in a mature stage. A lot of them have even reached their peak market share. For example, there are signs that Amazon is now losing market share in eCommerce. These days everyone is already on social media, everyone already has a smartphone, everyone has a Netflix account, and those that don’t are already Googling the alternatives. It seems like the household tech names have turned into somewhat of a consumer staple.
Regulatory risk
With that big of a success, the tech sector has proved to be the regulators’ favorite target. The EU commission alone levied $8.25 billion fines on Google. And in the US, there has been a lot of calls to break up the companies. Just last week, the US Department of Justice announced an anti-trust case against Google. Previously they used a similar case against Microsoft.
Based on all these factors, we believe that the tech stocks’ outperformance will not continue for too long. Of course, we are not advocating for short selling these companies, because as Keynes said:
“The market can remain irrational longer than you can remain solvent.”
Where to invest instead of tech
So if we don’t want to take on the risk of pretending that a $2 trillion company is a fast-growing startup, we ought to look at some healthier alternatives.
Retail
A large part of the investors are still scared of retail in 2020, and that may offer a great buying opportunity. Large brick and mortar retailers are uniquely poised to benefit from the COVID-19 crisis. The sudden shock was a wake-up call to the industry and has led the leading players to streamline their processes and drive eCommerce sales. Companies like Home Depot, Walmart, and Best Buy are all growing online sales at a rate of more than 100%. The BOPIS (Buy Online Pickup In-Store) option proves to be convenient for the customers and also very profitable for the retailer. Prior to 2020, who would have thought that the traditional brick and mortars would be the best eCommerce play…
Real Estate
There’s a lot of appeal in owning real, income-earning assets. That’s not the only reason you should own real estate, though. Interestingly enough, real estate (Nareit all REIT index) has outperformed the S&P 500 in the period from 1999 to 2020.
This is the market segment, where investors can find the best bargains right now. The Vanguard Real Estate Index Fund (VNQ) is still down 16% year to date, while some individual companies are down around 40–50%. Of course, these investments could be a bit riskier, considering the leverage levels usually employed by REITs, but the expected return more than makes up for it. Currently, the securities in this sector overall are priced as if they’d be facing declining cash flows in the next couple of quarters. However, we haven’t seen too many causes for concern. According to a report by Nareit, REITs have collected 95% of the due rent so far. For the more risk-averse investor — the best segment of the REIT sector is residential. Dividend yields are averaging 4–5%, which could lead to some double-digit yearly returns when combined with the expected capital gains. Overall this is a very stable industry, and companies have learned their lesson from 2008. Even while entering the recession this year, the balance sheets were healthy — there’s a lot of cash and available credit, and most importantly, high-quality earnings.
Office is the other sub-sector we’re currently looking at. Some of the smaller players in the field offer dividend yields in the range of 10%, while companies owning landmark properties in Manhattan are still trading at a discount to net asset value. That has to be one rare opportunity. If you believe that people will not work remotely forever and are eager to return to the offices, it’s hard to make a case on why office buildings should be trading at a discount.
It’s not all tech in the investment world, contrary to what most media says. We think that the excess return in the future is to be found in the small-cap equities in a healthy financial position. They have been somewhat forgotten in the recent rally, but when the dust settles and momentum is no longer the go-to strategy, the returns will surely catch up with the rest of the market.
