Despite an abrupt and punishing market swoon that disproportionately punished more volatile sectors, technology is holding its own. During the past month the sector has outperformed by roughly 100 basis points (bps, or one percentage point). Even with the prospect for more volatility, investors may want to consider adding to rather than abandoning the sector.
In June I highlighted why a regime of slow economic growth actually favors growth stocks over value. During the past three months, the Russell 1000 Growth Index has outperformed the Value Index by approximately 200 bps. Going forward, economic growth is likely to continue decelerating. This suggests a regime still favorable to growth and its largest constituent: technology.
Skeptical investors might reasonably assert that technology firms have already benefited from a multi-year rally, and as a result are not cheap. While true, there are several factors favoring the sector, including high profitability and an environment that increasingly favors secular growth.
Before addressing that regime, it is important to acknowledge the value argument. The sector trades at approximately 21.5 times trailing earnings and 20 times forward earnings. Current valuations compare favorably with the long-term average but look elevated relative to the post-crisis norm.
The story is similar when looking at relative value. The sector trades at a 10-15% premium to the broader market. This is above the post-crisis average of about 4%. That said, it is worth noting that relative value looks more compelling based on other metrics, notably price-to-cash-flow. On this metric the sector’s current relative valuation is below the post-crisis average.
The Tech Premium
To the extent tech does trade at a modest premium, it is because the sector is much more profitable than the broader market. The current return-on-equity (ROE) is approximately 34%, well above the post-crisis average and 18 percentage points above the broader S&P 500.
Finally, there is the regime. I made the point in early June that growth companies command a larger premium when economic growth is likely to slow. One manifestation of this phenomenon is the historically tight and negative relationship between the growth premium and the Treasury curve. A flatter curve, suggesting sluggish growth, has generally been associated with a higher growth premium.
The same relationship holds for technology stocks. In the post-crisis world, the shape of the Treasury curve has explained about 30% of the variation in tech’s premium to the broader market. With the 10-2 Treasury spread at a scant 10 bps, suggesting uninspiring future growth, the tech premium looks justified (see Chart 1).
Technology companies are not without their challenges. As mentioned earlier, the sector is not particularly cheap and is vulnerable to both domestic politics –i.e. greater regulatory scrutiny — and the vagaries of the current trade skirmish. That said, as long as we remain in an environment in which growth is scarce and at risk, investors are likely to continue to pay a premium for companies that generate earnings and cash flow what may.