This time is different—the four most sinister words on Wall Street, often uttered at a bubble’s peak. But if you talk with tech fund managers today, that’s exactly what they’ll tell you, despite record-breaking levels in the tech-laden Nasdaq index. The surprising thing is they may be right— at least partially.
Rahul Narang has every reason to be skeptical. He was a short seller betting against technology stocks in the 1990s dot-com bubble before he became manager of the Columbia Global Technology Growth fund in 2012. But he sees distinct differences between now and then. “The forward price/earnings ratio for the average tech stock is 19 today versus the S&P 500’s 17.7,” he says. “This compares to a 53.5 average P/E for tech in March 2000. So valuations are significantly cheaper versus the bubble.”
While tech is trading at a premium to other sectors, historically it always has, and right now the valuation spread is among the narrowest in the past 30 years, Narang says. At the end of June, the P/E spread between the average tech stock in the Standard & Poor’s 500 and the rest of the key index was 1.03 times; in 2000, it exceeded two times.
Of course, Apple (ticker: AAPL), which accounts for 15% of the S&P 500’s tech weighting, has a disproportionate influence on the valuation. And “Apple, by far, is one of the cheapest stocks out there,” Narang says. “Our analysts have a base case target valuation of 15 times [fiscal 2018’s] earnings, which gets you to $184 a share. That’s just the base case, and it’s still trading at a discount to that [at a recent price of $161] and the overall market. Then you add in the about $50 per share of cash on its balance sheet, and that it’s paying a dividend, and it squarely fits in the value camp.”
THE PROBLEM WITH APPLE is the law of large numbers. It’s an $825 billion behemoth. “A lot of large-cap tech companies have seen their valuation multiples compress because their growth is stagnating,” says Ken Allen, manager of the T. Rowe Price Science and Technology fund. “Apple is so massive now, it’s hard to grow very much. So it’s valuation multiple has come down. IBM’s [IBM] multiple has stagnated, as have [those of] Hewlett Packard Enterprise [HPE] and HP Inc. [HPQ]. There tend to be reasons for many of these stocks seeing multiple compression, and many of these companies are fairly large.”
That compression among the old-school technology giants, Allen argues, is masking the fact that other tech companies have become expensive. “As I look across the various tech stocks, many of them have much higher valuation multiples, versus where they were a year ago,” he says.
Yet Amazon.com (AMZN), which has a 246 trailing P/E, according to Morningstar, is Allen’s largest holding. Allen and Narang, who also owns Amazon, make the case that it’s investing heavily in growing its business, so its earnings are artificially depressed.
“If you start using traditional valuation metrics, you’ll miss the growth opportunity,” Narang maintains. “So what we try to do is spend a lot of time thinking about total addressable market, or TAM. If you think about Amazon, seven years ago it was valued as a traditional retailer. But they caught the cloud-computing opportunity, and they had a seven-year lead in that space, which is unheard of in the technology industry. For the cloud business, the TAM is very big—hundreds of billions of dollars.” Morgan Stanley recently pegged the TAM for cloud computing at $340 billion by 2020.
In addition, the model for how technology is purchased and consumed has changed, perhaps justifying higher valuations for players such as Amazon, Netflix (NFLX, 207 trailing P/E) and Salesforce.com (CRM, 486 P/E). “The big drivers of tech back in the 1990s were more hardware companies like Intel [INTC] and Dell,” says Michael Lippert, manager of the Baron Opportunity fund, which has 58% of its portfolio in tech. “Most of the revenues for hardware were one-time revenues. The company that sold you that product never really saw or heard from you again. They didn’t have a continuing relationship with you.”
TODAY, MANY TECH PRODUCTS are subscription-based, and companies have interactive relationships with consumers. Netflix, for example, knows what you like to watch and gives you recommendations, as does Amazon Prime. Both keep you on the hook indefinitely. “Because of that dynamic, you have much more visibility on the revenue and earnings stream, and you have much stickier businesses,” Lippert observes. This merits higher valuations, he argues.
Traditional value managers don’t buy this argument, yet they’re still investing in tech. “Who’s to say Amazon’s unbeatable?” asks Stephen Yacktman, co-manager of the AMG Yacktman Focused fund, which has a surprising 25% tech weighting for a value fund. “You would have said that about Wal-Mart Stores [WMT] 20 years ago. Technology changes so rapidly it’s hard to stay on top.” Instead, Yacktman owns old-school names, such as Cisco Systems (CSCO), Oracle (ORCL), and Samsung Electronics (005930.Korea). “We own the companies that were popular in 1999,” he says. “But if you talked to us then, we’d have said we’d never own tech.”
