US technology companies are much better value than many investors and commentators think, according to EdenTree Investment Management’s Thomas Fitzgerald.
The manager, who co-manages the £396m EdenTree Higher Income fund alongside FE Alpha Manager Robin Hepworth and David Katimbo Mugwanya, said while the wider US market is indeed expensive, tech stocks look relatively cheap based on a number of metrics.
The S&P 500 has been on an incredibly strong run over the past decade, returning 167.32 per cent to investors, as the below chart shows, sending valuations higher.
Performance of indices over 10yrs
Source: FE Analytics
However, the S&P 500 Information Technology index has performed even better, returning 214.08 per cent over 10 years and valuations have run even further than the wider market.
“We do think that the US market is expensive and that is reflected in our funds. If you look at any of our global equity funds you will find that we are underweight the US and have been for at least the last two years,” Fitzgerald said.
“In that respect we are with consensus but in terms of the technology sector I think we slightly differ. I believe that tech is actually undervalued.”
There are a combination of factors that the manager identifies as to why the technology sector is cheap when compared to the wider market, with the first being the heightened potential for growth.
The large technology stocks, also known as the FANG stocks – Facebook, Amazon.com, Netflix and Google – are delivering sales and earnings growth that far exceeds the broader market, he noted.
“In a low growth environment earnings growth becomes a scarce commodity essentially so you pay up for areas of the market where you can actually find that growth which is relatively hard to do,” the manager added.
Indeed, over the last 12 months, Fitzgerald said that the top 10 listed US technology companies have generated around $190bn in free cashflow.
For comparison, that is higher than the total cashflow over the same period for all the listed companies in the UK excluding the financial sector.
“That is quite phenomenal and differs vastly from where we were in 2000 when you had a number of listed companies in the tech that weren’t generating profits and some weren’t even generating sales,” he added.
The second reason technology names look cheaper is that the sector has much more breadth and the companies within it have much further reach than ever before.
“We are at levels now in the US tech sector that we haven’t seen before from a company standpoint,” he noted, with the likes of Apple, Twitter and numerous other technology companies becoming more and more important in the market.
“You have these companies which are essentially giants of the economy, not just of the sector. Technology conglomerates in Alphabet, Facebook and Apple are companies that are drivers and catalysts for change and disruption and that is across multiple sectors.,” Fitgerald said.
“Technology is now, for the first time, touching every industry vertical in the global economy. These companies have achieved vast levels of scale in terms of their market reach, market share and their balance sheet strength over the last couple of years to the tune that they are now generating more cash than some G20 economies.”
He said this phenomenon of improving earnings growth and increasing scale are two drivers that are unlikely to reverse or even diminish in the near-term.
Turning to valuations, the manager said the technology sector is currently on a price-to-earnings ratio of 30 times based on current year’s earnings.
However, if you take a consensus of analyst expectations for next year’s earnings figures, this falls to just 17.5 times – a figure which is in-line with the wider market over that metric.
In the second quarter of 2017, the sector generated 10 per cent sales growth and 16 per cent earnings growth compared with the wider market which generated sales growth of 1 per cent and earnings growth of 5 per cent.
Currently, the manager is forecasting that the US technology market should achieve around 10 per cent earnings growth for next year.
While analysts’ estimates can often be revised down over time, typically it is not a broad market or sector phenomenon, he added.
“Indeed, the areas of the market that we are looking at – where we see structural strength in the tech sector – we are actually seeing estimates coming up. Or at least they have done over the last 12 months,” Fitzgerald said.
As such, for the US tech sector to be trading in-line with the wider market is unfair, the manager said.
“If you look at the relative valuation of the US tech sector relative to the broader US market historically it has actually traded at an 11 per cent premium over the last 10 years on average on that measure,” he noted.
“It is in-line today despite what we’ve already mentioned already in that these companies have great scale and are much more profitable than they were 10 years ago and they’re turning those profits into hard cash.”
When looking at the technology sector, the manager said the team uses four key values to determine the bottom-up opportunities.
“In our stock selection framework we look at companies that have strong IP [intellectual property], a clear strategy, market leadership and high margins,” Fitgerald said.
“Within that you have the top technology names where there are some that line up with that framework and there are some that don’t.”
An example of a company that does fit into this selection process is Alphabet, the parent company of Google, despite its strong performance over the last decade.
Performance of stock over 10yrs
Source: Google Finance
The main reason the manager is keen on the stock is its market leadership as well as the scale and breadth of its consumer base.
“Alphabet, the last time I checked, takes home about 50 cents of every dollar that is spent on online advertising so it has got clear market leadership there,” he said.
Additionally, it has got scale in terms of its market breadth, with more than one billion users globally in each of its Youtube, Google Maps, Gmail, Google Search, Android and Google Play products.
“That is the market scale that they have achieved and as they roll out new products they have an instant install base,” he noted.
However, it also ticks boxes in terms of margins, generating operating margins of more than 30 per cent and a return on invested capital of more than 30 per cent as well.
“It is a highly profitable business and is still growing in terms of sales and earnings growth and the valuation is not typical of what you would consider a lofty valuation for the tech sector,” Fitzgerald said.
“Based on our earnings estimates we have got it on a sub 20 times P/E for 2017 and 2018 respectively. So, a moderate premium to the market for a company that is growing earnings in excess of 20 per cent per year and is indeed turning those earnings into hard cash.”