Rather than avoid tech altogether, investors will simply need to become more selective
Author of the article:
David Rosenberg and Brendan Livingstone, David Rosenberg
Within the technology sector (and the market as a whole), focus on highly profitable companies, with stable margins, that also trade at reasonable valuations. Photo by Getty Images/iStockphoto files By David Rosenberg and Brendan Livingstone
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Stocks have started the year on an uneven footing, primarily amidst concerns of higher interest rates.
Between Dec. 31 and Jan. 10 (when the S&P 500 bottomed), the 10-year TIPS yield rose every single trading day, and by 33 basis points in total. This is a relatively small move based on what has transpired at various points in the past, but depressed interest rates are a key component to the bull case for stocks.
After all, the 10-year Treasury Inflation-Protected Security (TIPS) yield has been negative for the entire pandemic recovery, helping to at least partly justify a forward P/E multiple of 21.1x (well above the historical average of 16.2x). Consequently, if we were to see a sustained move higher in government bond yields, while not our expectation, this should remove a key source of support for valuations and, by extension, stocks.
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The technology sector, which trades at a forward P/E of 27.4x, would appear to be especially vulnerable in the aforementioned environment. This is because these stocks tend to derive a greater share of their cash flows in the future — relatively speaking — which makes them more sensitive to shifts in the discount rate. With this in mind, it shouldn’t be a surprise that the sector underperformed the broader market in the rate-induced selloff earlier this month, falling 4.6 per cent versus the two per cent pullback in the S&P 500.
We dug a little deeper into this development. The tech sector, in general, fared poorly, but there was a wide dispersion in performance among the individual names. Interestingly, we found the best indication of how a given stock performed was its forward P/E ratio, which is consistent with our a priori expectation that, all else being equal, high-multiple companies should lag in a rising rate environment.
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For example, the cheapest quintile of tech stocks had an average return of 3.1 per cent over this period versus the -11.6 per cent decline for the most expensive quintile (see accompanying table).
We extended this analysis beyond just the tech sector and looked at the whole S&P 500. Once again, stocks with the lowest forward P/E multiples outperformed over this period, rising 4.2 per cent (on average). In contrast, companies that trade at high price-to-earnings ratios meaningfully lagged, declining 6.6 per cent.
To us, this reinforces that screening for companies with favourable valuations, at this stage of the economic/market recovery, is critical. While 2021’s stock market performance can best be summarized as “a rising tide that lifted all boats,” we expect returns in 2022 will be far more uneven as valuations normalize (particularly if interest rates continue to rise).
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However, in our view, there is too much focus on the technology sector as being negatively impacted by higher interest rates. It is true that, overall, the sector is at risk, but this is a broad generalization. Indeed, as our earlier analysis showed, share prices of the cheapest stocks within the sector actually rose even as the most expensive names were hit hard. Thus, rather than avoid tech altogether, we believe investors will simply need to become more selective on this front.
Beyond valuations, we also see earnings growth and margins as being key drivers of performance this year. Regarding the former, as gross domestic product growth slows, owning companies that have a history of delivering strong earnings growth, throughout an entire economic cycle, should bode well for their continued success going forward. In addition, we believe screening for favourable margins will help guard against the cost-push inflationary pressures that we have seen. This is especially the case given the Omicron variant has pushed out the timeline for a normalization in supply chains.
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More On This Topic David Rosenberg: If you receive kindness, remember to also give some in return Outlook 2022: Time to take risk off the table, says David Rosenberg David Rosenberg: You don’t need a recession for investors to have a tough year Within the technology sector (and the market as a whole), our focus would be on highly profitable companies, with stable margins, that also trade at reasonable valuations. In terms of tech sub-industries that fit this characterization, our screen ranks semiconductor equipment, semiconductors and systems software as most favourable.
Admittedly, systems software trades at a rich valuation (31.1x forward earnings), but it does have the benefit of having the highest profit margin of the group (35.7 per cent) and among the best EPS growth (21.1 per cent annualized over the last five years).
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Article content Conversely, IT consulting and services, electronic components and electronic manufacturing services all score poorly. This is because of their weak profitability/margins, meaning they are trading at a lower P/E ratio for good reason (the opposite of systems software). This is why it is important to look beyond valuations — sometimes they don’t tell the whole story.
We expect 2022 will be a period where P/E multiples compress, all the more so if interest rates continue to move higher. Against this backdrop, we anticipate high-multiple names will underperform, as has been the case so far this year. However, this dynamic is not unique to tech, so it is not a reason to indiscriminately avoid exposure to the sector.
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Article content Instead, we would screen for reasonably valued companies that are highly profitable and have stable margins. At a sub-industry level, the best examples of this are semiconductor equipment, semiconductors and systems software, which appear well positioned going forward, even in a rising rate environment.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Brendan Livingstone is a senior market strategist there. You can sign up for a free, one-month trial on Rosenberg’s website .
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