Overall, valuations for the U.S. equity market appear fair to us at current levels, reflecting the strong economy and the bright corporate earnings backdrop balanced against the risks of trade and rising interest rates.
Looking at valuations in the technology sector in particular, there are some pockets of rich valuations that grab headlines. But when looking broadly across technology stocks, they are trading at a slight P/E premium to the overall market, about 18.6 vs. 16.5x for the S&P 500 (Sourece: Factset, as of August 17, 2018.).
We see the technology sector premium as well deserved, given that technology companies have delivered the best growth over the past three years and should be able to continue to see strong growth in the coming years. Additionally, from a quality standpoint, the technology sector has some of the highest margins and best balance sheets in the market, according to our research (Source: FactSet, based on three-years through August 23, 2018.).
It is also worth noting the technology sector has changed dramatically over the past 20 years., In our view, comparisons to the late 1990s “Tech Bubble” are not rational. Tech companies today have been highly profitable and are much less levered. Revenue is less economically sensitive and more focused on software and services, which have the potential to bring recurring revenue that would likely be more stable in an economic downturn.
Growth And Value Investing: Is The Tide Turning?
“Growth” has outperformed “value” as an investment style since the end of the financial crisis (Source: Russell Indices. Calculation period December 31, 1988 through January 1, 2018.). The market has rewarded companies that can produce consistent earnings and cash-flow growth in what has been until recently a modest GDP-growth environment. The low-interest-rate backdrop has created an additional tailwind for growth equities where investors are often looking out 3-5 years at a company’s growth potential and discounting those profits back to measure a company’s fair value today.
In recent months, we have seen performance of value stocks improve, coinciding with the acceleration of economic growth in the first half of the year and the rise in short-term interest rates.
Despite this near-term value outperformance, I think many traditional value industries are facing significant competitive challenges from faster-moving competitors or new well-funded entrants. When we look across the investment landscape, we see the pace of disruption is accelerating and many traditional value industries face rapidly changing competitive environments. In my view, much of this risk is not captured simply by a low valuation multiple, and some investors may risk falling into a trap.
Some examples of old line, traditional value industries that are facing new competitive challenges include the transportation sector, where cheaper and faster competitors are rethinking how we move people and goods, and the retail sector, where online competition is driving prices down for consumers and in turn limiting pricing power for traditional brick-and-mortar retailers.
In the industrials sector, we are seeing companies embrace digital transformation and the use of data analytics. Robotics and artificial intelligence are shifting long-held cost advantages.