Since peaking in November last year, the Nasdaq Composite Index – a proxy for the US technology sector – has declined by 17%. While valuations at the high point of the index were stretched and posed a clear risk to investors, they are now heading towards more palatable levels. Although we don’t yet see the US tech sector as attractively priced in aggregate, we are starting to keep an eye open for opportunities to add select names to our clients’ portfolios.
In September 2021, we wrote that elevated valuations were the key risk investors faced with regard to US tech stocks. At the time, the Nasdaq Composite Index was trading at a 30 times forward price-to-earnings (P/E) multiple, 50% higher than its average over the preceding 15 years. While we were comfortable that earnings would continue to grow ahead of the overall economy, our view was that the prices of these shares were already reflecting that growth. So, while we liked many of the individual businesses, our portfolios reflected substantially lower exposure to US tech than the benchmark index.
Over the following two months, the Nasdaq gained a further 7%, and I must admit I felt a bit like that boring friend at a party who tells you to go easy on the tequila. However, since its November peak, the Nasdaq is down 17% (15% year to date), while its maximum peak-to-trough drawdown exceeded 20%.
The Nasdaq’s significant decline can be ascribed almost solely to changes in valuation, with the index’s aggregate 2022 profit expectation up 1% and the multiple that the market is paying for those profits down 16%.
As 2022 dawned and markets realised that persistent inflation in the developed world would lead to more rapid and aggressive action from central banks, valuations were adjusted to reflect a higher interest rate environment. Back in September, the futures market expected no increase in the US Federal Reserve’s federal funds rate through 2022, yet by early February 2022 it had priced in seven rate hikes this year.
As a reminder, all assets are to some extent priced off the US federal funds rate – the so-called ‘risk-free rate’. As this rate rises, so the present value of expected future cash flows declines. The further in the future that cash flows are expected, the greater the impact of higher rates, and the share prices of high-growth companies were therefore in the main hit harder than those of their less racy peers.
High valuations are also typically more sensitive to geopolitical events – such as the Russia-Ukraine war – and their impact on the market’s risk appetite. This comes from both greater sensitivity to higher discount rates (in this case due to lower market risk appetite) and the fact that the earnings estimates for such companies often factor in a near-best-case scenario.
The above points are most clearly illustrated by the fact that the MSCI World Growth Index has underperformed the MSCI World Value Index by more than 11 percentage points so far this year.
NOTABLE TECH DECLINERS
Among the more notable US tech decliners in the first two and a half months of 2022 are Netflix, PayPal and Meta (Facebook), all down more than 40% at the time of writing. These significant drops illustrate the double whammy for companies when lofty earnings growth expectations are moderated and the multiple that the market is willing to pay for such earnings contracts.
The market’s consensus estimate for PayPal’s 2022 profits fell ‘only’ 11%, but the share price dropped 35% in the two weeks after its results announcement as the forward P/E multiple contracted nearly 30%. A seemingly mild change in a company’s growth outlook can have an outsized impact on its share price when the valuation is stretched to begin with.
Even though the Nasdaq’s forward P/E multiple has contracted by 19% since the November high of 32 times to a more palatable 26 times, it remains more than 20% above its average over the past 15 years. We therefore don’t yet regard the US tech sector as attractively priced in aggregate – but the valuation risk has certainly diminished.
WATCHING FOR OPPORTUNITIES
We continue to see many of today’s tech giants as excellent businesses given their natural monopoly or oligopoly business models and consequent growth prospects, cash-rich balance sheets and resilience to the economic cycle. Many of these are businesses that we’d want to own, at the right price.
With tech valuations heading towards more palatable levels, we’re keeping an eye open for opportunities – and we’re edging closer to the point where we may begin to add US tech names to our clients’ portfolios.