Tech Stocks May Be Both Cheap and Risky

June 12, 2017

As a sign of vulnerability in the (so far) high-flying technology sector, many of the biggest names tumbled towards earth on Friday. Among the so-called FAANG five, the declines for the day were: Facebook Inc, Apple Inc, Inc. Netflix Inc, 4.7%, and the parent of Google, Alphabet Inc. The tech-heavy Nasdaq 100 Index shed 2.4% of its value on Friday, per data from Nasdaq, while the tech stocks in the Nasdaq 100 were off by 3.6%, also per Nasdaq. As a point of comparison, the S&P 500 Index (SPX) dipped by less than 0.1%.

Eggs in One Basket

On Thursday, Bank of America Merrill Lynch, a division of Bank of America Corp, released a report indicating that the tech sector offers both risks and opportunities for investors. In May, tech was both the best-performing S&P 500 sector and the one whose price-earnings (P/E) ratio increased the most, according to Merrill Lynch. At approximately 19x as of the report’s issuance, Merrill notes that this is the tech sector’s highest valuation since the financial crisis.

Moreover, tech is more overweight than it ever has been, among large cap actively-managed funds surveyed by Merrill since 2008. In their May 30 Active Managers’ Holdings Update, Merrill notes that survey respondents are 24% overweight in tech, almost two standard deviations above average. Yet more striking is the fact that fund managers are 71% overweight in FANG stocks (Merrill excludes Apple), though this weight has been flat for a year. The bigger picture is that funds have made a record shift from value to growth sectors over the past 12 months, leading Merrill to prefer value to growth right now.

Conflicting Valuation Signals

Nonetheless, Merrill says, “But although Tech’s 8% premium to the S&P 500 P/E is the biggest premium we have paid since 2010, it is still low relative to history, even excluding the Tech Bubble.” Moreover, Merrill finds that all industries within the tech sector are sporting P/E ratios that are lower than or in line with their “historical average relative P/E multiples.” Closing out the positives, Merrill says that tech screens as most attractive according to their quant models.

On the other hand, based on its enterprise value (EV) to sales ratio, tech is trading at its highest relative multiple since the tech bubble. Exclude the bubble period, and tech currently is still valued well above the average for this metric, Merrill says. Additionally, Merrill finds that inconsistent accounting treatment of stock-based compensation, which is a large expense for most tech companies, might cause tech’s P/E to be understated by as much as 10%. Bottom line: Merrill is marketweight in tech, based on these conflicting valuation signals.

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