Can a Growth Scare Benefit Tech Stocks?

Given the recent volatility, investors may be wary of tech. Not so fast, Russ explains.

Despite an abrupt and punishing market swoon that disproportionately punished more volatile sectors, technology is holding its own. During the past month the sector has outperformed by roughly 100 basis points (bps, or one percentage point). Even with the prospect for more volatility, investors may want to consider adding to rather than abandoning the sector.

In June I highlighted why a regime of slow economic growth actually favors growth stocks over value. During the past three months, the Russell 1000 Growth Index has outperformed the Value Index by approximately 200 bps. Going forward, economic growth is likely to continue decelerating. This suggests a regime still favorable to growth and its largest constituent: technology.

Skeptical investors might reasonably assert that technology firms have already benefited from a multi-year rally, and as a result are not cheap. While true, there are several factors favoring the sector, including high profitability and an environment that increasingly favors secular growth.

Before addressing that regime, it is important to acknowledge the value argument. The sector trades at approximately 21.5 times trailing earnings and 20 times forward earnings. Current valuations compare favorably with the long-term average but look elevated relative to the post-crisis norm.

The story is similar when looking at relative value. The sector trades at a 10-15% premium to the broader market. This is above the post-crisis average of about 4%. That said, it is worth noting that relative value looks more compelling based on other metrics, notably price-to-cash-flow. On this metric the sector’s current relative valuation is below the post-crisis average.

The Tech Premium

To the extent tech does trade at a modest premium, it is because the sector is much more profitable than the broader market. The current return-on-equity (ROE) is approximately 34%, well above the post-crisis average and 18 percentage points above the broader S&P 500.