Technology stocks seem unstoppable. Giants like Apple and Microsoft, as well as technology-driven consumer firms such as Amazon and Alibaba Group, continue to do well through the COVID-19 pandemic. Meanwhile, an emerging group of resilient, innovative leaders, ranging from cloud-based service providers and fintech to ecommerce enablers, also show solid growth, fueled by rapid business and consumer changes brought by the pandemic.
The tech-heavy Nasdaq Composite Index has surged by 20.5% this year through July 31, while the MSCI World Technology Index is up 20.8% for the period. When compared to the more muted rebounds of the S&P 500 and MSCI World indexes, it’s clear that investors are giving tech stocks their day in the sun.
Strong gains have pushed up valuations of technology stocks. Global technology stocks trade at a price/forward earnings valuation of 26.5x, a 30% premium to the MSCI World Index. Is the gap warranted or based more on irrational animal spirits? In these unprecedented times, we think some high prices are justified, especially for companies with sustainable growth drivers. Investors just need to get past a few myths to find the opportunities.
Myth #1: All Tech is Overpriced
Technology is not a homogenous sector, and not all tech companies are overpriced. In fact, the sector’s valuation premium is relatively low versus its historical high (Display).
At the market’s peak in March of 2000, the MSCI World’s technology and communication services sectors combined accounted for 35% of market cap and less than 18% of the earnings. But today, the two sectors represent 30% of market cap yet almost 25% of all earnings (Display). The reason? In an ever more web-connected world, tech companies increasingly enjoy the positive benefit of the network effect, allowing them to take advantage of scale and generate higher incremental margins.