Profit growth is by far the strongest contribution to performance, but the B/U ratio now seems to be a brake.
Since the financial crisis of 2008-2009, the technology sector has performed impressively at an annual rate of 15.4%, far outperforming global equity (10.2%) and even growth-oriented equity (11.5%). The year 2018 seems to continue this trend with an intresting news, increase in lstest global tech actions of nearly 12% at the end of July, outperforming their counterparts “growth” (7%) and global actions (4%).
Prior to 2018, investors benefited primarily from three sources of performance: profit growth, dividend growth, and the expansion of the price-to-profit ratio. Investors are right to think that the news about profit growth has been the key driver of performance in the latest global tech sector since the crisis, but in reality it has accounted for only 49% of total performance. The expansion of the B/U ratio proved to be another significant source of performance, accounting for 37% of total performance over the period.
Since the beginning of 2018, performance engines have changed dramatically. Profit growth was by far the strongest contribution to performance, but the B/U ratio now seems to be a brake.
In terms of future performance, it seems unlikely that the B/U ratio will be able to truly regain its role as a driving force for the sector, as it has been since the financial crisis. Outside of the tech bubble of the 2000s or periods of recession and crisis, the sector posted a price-to-earnings ratio that remained in trend around 22-25 times. It now seems clear that, in the absence of a bubble, the technology sector will no longer be able to rely on a “re-rating” of P/E ratios to achieve performance in the years to come.
Building on profit growth
and deal with increased volatility.
As recently observed, greater reliance by investors on earnings growth to boost the performance of the technology sector – even if this is not new to them – also means that they must expect greater volatility in this sector.
Indeed, with technological actions that treat the sliding profits at nearly 24%, these are in the upper range of the 22-25x, which serves as a historical reference but also as a constraint for valuations. If the multiples, already above their 2018 peak, were to contract down to 22%, this would suggest that the year-on-year performance would remain positive but with a possible 4% decline from current levels.
If, on the other hand, the multiples remained close to their current levels, investors might consider that the expected profit growth of 22% for 2018 could sustain an additional 4-5% total performance by the end of the year. In a more optimistic scenario, if the B/U ratio were to return to 25%, the highest in 2018, investors could then expect an additional 11% performance, in addition to the 12% already achieved at the end of July.
Opportunities still attractive
Although investors must expect increasingly volatile absolute performance, the attractiveness of the technology sector remains intact. Technological stocks are in fact a major component of growth stocks in the US market, which fueled the strong outperformance of “growth” stocks (+10.4%) compared to return stocks or “value” (+2.2%) at the end of July. Thus, us growth stocks, drawn by technology stocks, do not actually show any signs of fundamental divergences, contrary to what was observed just before the technology bubble of 2000.
Investors should Disengage passive exposure to technology
The continuous improvement in the return on equity (RoE) of us technology stocks is indeed one of the main reasons for the strength of last year’s rally. The RoE for the sector has thus increased from a range of 15-20% in the pre-2008 cycle to a stronger range of 20-25% (or more), thanks in particular to the growth in share buybacks and an increase in profit distribution rates since 2012.
The tax cuts implemented across the Atlantic in 2018 have logically contributed to the recent” re-rating ” of the roes in the technology sector. Since remittance rates among U.S. technology companies are still at a modest 20% level compared to other sectors, they still seem to be largely able to continue to use these share buyback and dividend-raising programs to sustain profits and performance.
Thus, despite this regime shift – and notably an expansion of the B/u ratio that is no longer an engine of performance – the improvement in the performance profile of the technology sector relative to the broader market (especially in the United States) suggests that this sector will continue to be attractive to securities selectors. They will have to be able to turn away from societies exposed to the contraction of multiple, to prefer those with permanent and regular profits, as well as prospects of stable valuations.
As a result, investors should Disengage from passive technology exposure (i.e. index-based), instead seeking to take advantage of the active Management opportunities that are expected to emerge following the regime change in this sector in 2018.