In a sense, the poor performance this year for tech and growth companies is somewhat of a payback for the impressive returns these market segments had recently enjoyed. From the market low in March 2020 through the end of last year the Russell 1000 Growth and NASDAQ rose about 135%, outperforming the S&P 500 by 15 percentage points.
Why the turnaround? Tech and growth stocks benefited from two tailwinds during the pandemic: a surge in stay-at-home spending, which drove explosive earnings growth; and extraordinarily low interest rates, which boosted valuations. These tailwinds have turned into headwinds this year with consumer and business spending shifting away from pandemic activities (e-commerce, digitizing businesses) and higher interest rates. Perhaps this year can be thought of as the “hangover” from the boom times in 2020/21.
Despite the now lower valuations for tech and growth stocks, we still prefer value over growth, and we are neutral on the sectors where most of the “tech” companies reside: communications services, consumer discretionary, and information technology. While we think that long-term interest rates have peaked for now, growth stocks are still expensive relative to value stocks. At a price-to-earnings ratio (P/E) of nearly 24x, the Russell 1000 Growth index still trades at a 66% P/E premium to the Russell 1000 Value index. The long-term average premium is 35%. Right before the pandemic, the P/E of the Russell 1000 Growth index was about 20x.
Plus, value stocks will likely produce faster earnings growth relative to growth stocks this year. Bottom-up consensus analyst estimates imply 20% earnings per share (EPS) growth for the value index compared with only 10% EPS growth for the growth benchmark. In addition, in periods of above average nominal GDP growth—which we expect to prevail for some time— value companies typically produce faster earnings growth relative to growth companies. Furthermore, we cannot rule out additional earnings downgrades for growth companies as spending patterns continue to normalize. Finally, long-term growth estimates for the Russell Growth index still look lofty. Analysts are still expecting growth companies to generate 16% annual earnings growth over the next 3-5 years. The pre-pandemic average was 14%.
Our preference for value stocks does not mean that investors should have no exposure to growth stocks. Rather, investors should tilt portfolios towards value stocks. Still, we would be especially careful about investments in more speculative growth companies that have less proven business models and/or businesses that don’t generate much, if any cash. While many of these companies have suffered sharp stock price declines, continued Fed interest rate hikes and slowing economic growth suggest that investors will likely continue to gravitate away from these types of companies.
In the tech complex, we continue to prefer quality growth, some value as well as mid-cap technology companies. One of the main takeaways from 1Q22 earnings season was continued, healthy corporate IT spending. We think this bodes well for broad-based software vendors. These companies tend to have higher quality business models, limited consumer exposure, and now lower valuations. There may be some incremental downside on valuation, but we think the quality cohort in software will see healthy earnings growth that should largely offset this compression.
We would also focus on the large digital advertising platforms. While regulatory overhangs will persist, we think that there will be little impact on companies’ fundamentals. Competition has increased, but we think the large domestic platforms are advantaged by user demographics that are most attractive to ad buyers. Furthermore, we believe current valuations do not reflect longer-term growth prospects.
“Value” and “technology” is not typically a winning combination, because many “cheap” technology companies tend to be market share losers, in our view. In general, we would steer clear of these types of companies. However, some technology companies in the hardware and semiconductor industries appear well positioned in the current environment at below-market P/E multiples and with attractive dividend yields. Finally, we would have a tilt towards mid-cap technology companies. This group trades at nearly a 20% discount versus its large-cap peers despite a faster earnings growth outlook. Most of the widely owned mega-cap FAANG companies are higher quality and/or leveraged to more durable growth drivers and should be better positioned. For stock specific recommendations, please see our CIO Equity Preference Lists.
Overall, the macro environment for tech and growth companies may continue to be a headwind and investors will have to be much more selective within these market segments.
Main contributors: Solita Marcelli, David Lefkowitz, Kevin Dennean
Content is a product of the Chief Investment Office (CIO).
Original report - US Regional View: The hangover in tech stocks, 16 May, 2022.