Technology stocks can still pay off, but beware risks of passive investing

By Margaret Taylor

FOR too many investors, holding FAANG stocks (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) is coming to be an obligatory part of the investment process.

These firms’ valuations are often based on optimistic assessments of their future growth potential, but when it becomes apparent these projections are erroneous the correction can be dramatic, as the recent plunge in the share prices of both Facebook and Netflix demonstrates.

Technology has performed very strongly in recent years and now makes up a large part of global equity indices. While there is value in some of the “old” US tech names, there is an increasing number of red flags for investing in the sector.

One point to note is the continued shift to passive investing. The increasing prevalence of exchange-traded funds (ETFs), which invest in the whole market, is creating a virtuous circle for the FAANG stocks, which make up the largest part of the US equity market. As investing through ETFs involves buying shares without any regard to valuation it is easy to see how the FAANGs can rapidly become overvalued.

The growth in passive investing, and particularly ETFs, is a relatively recent phenomenon that has undoubtedly worked well for both investors and the FAANG stocks during the elongated bull market. However, this may unwind rapidly if and when markets turn.

It is becoming apparent that some investors are now taking a top-down view on the sector and targeting a specific weighting irrespective of the valuation of the underlying stocks. This suspension of the investment process is very noticeable in both UK and European markets, where there is a scarcity of tech and investors have to pay very full multiples to gain exposure.

In an environment of lower global growth, there is admittedly some rationale for paying a premium for faster-growing businesses. Nevertheless, many of the highly valued tech businesses are very large already, with market capitalisations in the hundreds of billions of dollars and share prices already discounting substantial future returns. Many of these tech businesses must therefore be considered high-risk investments.

Indeed, the market capitalisation of these relatively young companies, which are disrupting many aspects of business and the everyday lives of consumers, remains staggering. At some point governments across the world will have to look at the regulation and taxation of these companies.

It is hard to categorically state that any of these businesses are overvalued. However, investors have priced-in bold assumptions on the future rate of growth, technological change and challenges to their market positions, both from new entrants and regulatory challenges.

Crucially, while growth drivers such as the shift to the cloud, the internet of things, machine learning and autonomous vehicles are very interesting, older US tech stocks are actually a much cheaper way of playing these trends.

Cisco, IBM and Intel all have the characteristics value-orientated investors should look for in any investment. Their valuations are low because they are not pure plays on the new growth drivers. However, they are all investing massively in next-generation technology.

For example, Cisco is transitioning its business model away from a traditional “book and ship”’ every quarter model to a combination of hardware, software and recurring revenues. IBM has created a strategic-imperatives division, which is growing by 10 to 15% per annum and now represents over 40% of group revenue.

Intel, meanwhile, is trying to evolve from a personal computer company to one that provides the infrastructure for an increasingly smart and connected world.

There is value to be found in the technology sector – you just need to know where to look for it.

This article provided by NewsEdge.