Are Tech Stocks Too Expensive? | American Funds

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Will Craig Investment Analyst
investment perspectives

Are Tech Stocks Too Expensive?

Will Craig covers global internet companies. He has 12 years of investment experience, five with Capital Group. He holds an MBA from Stanford and a bachelor’s in Asian studies from UNC-Chapel Hill.

Key Takeaways

  • Tech’s weighting in U.S. markets is the highest it’s been since the tech-stock boom
  • Valuations in tech are still compelling due to unique and powerful business models
  • Expect tech stocks’ sway to increase as platform companies grow and gain market share

Surging technology stocks — think Facebook, Microsoft, Apple and Alphabet — are rapidly expanding their influence on the makeup and direction of the U.S. stock market. But while some might think this is a sign of excess or overvaluation, I suggest that, if anything, the sector’s influence will only intensify the next few years as the market appreciates these companies’ superior fundamentals and growth prospects.

There’s no denying tech stocks‘ power. Here’s a point-in-time measure that shows how important tech has become in 2017. The market value weighting of information technology stocks in the Standard & Poor’s 500 Composite Index reached 23% in early 2017, the highest level since the tech-stock boom in 2000, when it peaked at 34% in August 2000. Tech’s outsized role is even more pronounced in emerging markets, accounting for 30% of the market value of the MSCI China Investable Market Index (IMI) as of 2016. That’s up from less than 10% in 2000. And technology is the largest component in the MSCI Emerging Markets Index.
 

Tech’s Importance Rises Percentage of the S&P 500 market value in the information technology sector

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Source: MSCI, RIMES as of 6/30/17. MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.

Individual tech stocks tell the same story, too. Consumer electronics and computer software developer Apple saw its market value top $800 billion this year, the first U.S. company to reach that height — meaning this one stock accounts for 4% of the S&P 500’s market value. Overseas, Chinese internet giants Tencent and Alibaba are among the world’s 10 most valuable companies and some of the biggest drivers of returns over the past year, based on the MSCI ACWI index.

My analysis shows tech’s already large influence can grow even further, because:


1. Tech Stocks Don’t Seem to Be in a Bubble

Despite strong gains this year, tech stocks, specifically those in the internet space, offer value. Internet stocks’ price-to-earnings multiples are 140% higher than that of the S&P 500 based on 2018 estimates, but that number masks a more accurate picture of the opportunity. Internet companies’ free cash flow gives a truer picture of their ongoing financial power, as these companies trade at just a 55% premium to the market in free cash flow estimates for 2018, a reasonable price in my view for superior profitability. Internet companies’ return on invested capital, a measure of how much profit is driven from equity and debt invested in the company, is 26% higher than that of the S&P 500. Internet companies also enjoy valuation support due to holding 4% of their market value in net cash, as opposed to S&P 500 companies that carry net debt.

Internet Stocks Expensive? While Internet stocks recently traded at a 140% premium to the S&P 500 on a P/E basis, they trade for a much lower 55% premium based on free cash flow.

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Source: Capital Group as of 3/24/17. Based on 2018 estimates.

2. The Internet Is Still Rapidly Growing

Growth abounds in tech: Internet companies are expected to see their profit grow three times faster than the S&P 500 over the next five years. Interestingly, the internet companies growing the fastest can be bought at attractive valuations. Amazon.com, for instance, is expected to post compound average annual growth of more than 30% between 2016 and 2021, which outstrips all of its major internet industry peers. But the online retailer’s free cash flow multiple of 20 is still in line with, if not lower than, comparables.

Fast-Growing Internet Titans: Growth Seems to Offer Value

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Source: Capital Group as of 3/24/17.

3. Giant Tech Companies Can Get Even Bigger

The “winner takes most” dynamic of the internet — where the largest companies capture a majority of incremental business — creates opportunities for investors. This is what I call the platform paradox: Companies are growing faster as they’re getting bigger.

Despite being among the most valuable internet companies, both Amazon and Facebook are also the fastest growing based on expected free cash flow increases between 2016 and 2021. These massive companies are uniquely positioned to take advantage of the large amounts of advertising and e-commerce that will still move online.
 

Winner Takes Most: Internet Titans’ Growth Rates Increase With Size

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Source: Capital Group as of 3/24/17.

Technology has only begun to change businesses ranging from advertising to retail and travel. In a decade or two, there will probably be three to five trillion-dollar, and potentially multitrillion-dollar, technology companies powering the digital economy.

Given this favorable backdrop, when I hear that only 23% of the market’s value is from technology, I think that number should be far higher. I think that number will be far higher.

Investors looking to capitalize on what could be a coming era of mega-technology companies can look at these five select American Funds with significant investments in the technology sector and/or the large technology companies:
 

Select American Funds With Highest Tech Exposure

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Source: Capital Group as of 3/31/17. Table includes individual tech and tech-related stocks with the largest market values in the Standard & Poor’s 500 Index.

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