Tech stocks have been some of the best performers this year, but concerns have been raised about whether share prices are reaching unsustainable levels, echoing the dotcom bust of 2000.
The Nasdaq 100 index – which is heavily weighted to technology-focused firms – has been on a winning streak. But we saw a sharp sell-off in technology stocks in June, with the likes of Facebook, Amazon, and Apple all seeing a slump in shares. This prompted speculation of whether this was the start of a bigger unwind for the sector.
Yet with no compelling single catalyst for the sell-off, it’s more likely the shift was caused by profit-taking, as opposed to a clear rotation out of the sector.
Technology has accounted for nine of the S&P 500’s top 20 best performing stocks, as of 11 July.
But are we in bubble territory? The short answer is, no. While the technology sector has rallied, shares have risen alongside higher earnings, which has been the key driver of performance.
Importantly, the long term earnings growth for the sector is markedly higher than other industries across the market.
There are several drivers of growth that will enable technology companies to sustain their earnings growth over the long term.
First, the “network effect” helps to sustain the market position of the technology titans of today, because the more users that engage, the more powerful these companies become. Ultimately, the big get bigger.
As the cash flow and earnings of these companies grow, they can invest even more in high growth areas, such as artificial intelligence and autonomous driving.
Second, the shift to cloud computing is expected to accelerate over the coming years, accounting for a significant portion of computing workload and eventually replacing more traditional forms of technology.
Microsoft is a good example where the business has pivoted its revenue model towards subscriptions and is positioning as one of the best providers for public cloud services, specifically for large enterprises. The recurring revenue stream enables greater visibility and more sustainable earnings growth, supporting the company’s valuation today. Its cloud computing platform Azure, is arguably the free option that is yet to be fully priced into the stock, and will accelerate growth as the move to cloud services gains more momentum.
One of the main factors underpinning the dotcom bubble burst in 2000 was that investors were indiscriminately buying the stocks of any internet company, including those without any revenues or working business models. Many speculators were burnt by buying heavily into these stocks.
However, in recent years, the top tech companies have shown healthy profits and many have accumulated robust sums of cash over the years. Tech companies also have the infrastructure to support the continued growth of their businesses, such as fibre optics.
Technology valuations in general are not unrealistic, given the strength of earnings growth they offer. Outside of some heated pockets, there are still good stock picking opportunities to be found in areas such as semiconductors, system software, and the internet. However, it’s important to identify those companies where the share prices are yet to reflect their true growth potential.
So while the current state of the tech sector might resemble the issues leading up to the dotcom collapse 17 years ago, there are many signs it will hold up and continue to create healthy returns for investors.