Misconceptions and Truths of Investing in Tech Stocks (Part 2)
by Patrick Oberhaensli, on Nov 23, 2020 1:13:00 PM
In the first part of our investing in tech stocks article series, we examined the most common misconception of a largely diversified tech index. In this second part, we will address two additional ones. The first is that the comparison of value stocks is expected to be in favor of value stocks long-term. The second is that the Price/Earnings (PE) ratio of tech stocks is thought to be “constantly” very high which can be used as a key characteristic for growth. With no surprise, the reality is quite different in both cases…
Growth Stocks vs. Value Stocks
Are US growth/tech stocks long term less attractive than value stocks? Really?….
Well, that depends first on how the investor defines growth and value stocks and what is long-term… When it comes to the US, listed growth stocks are for the most part tech stocks in the context of a NASDAQ. Normally the time frame we talk about when we say “long-term” is 30 years or more.
Now, considering the end of 1992 as the starting point (almost 28 years ago), an investment at 100% in US growth/tech stocks would currently be at 1570% (as per 4th of September 2020) while a value stock investment would be typically between 305% and 655% considering different value approaches. Of course, the first problem is to specify what the growth and value styles are and there aren’t really any standards available. This is a key problem because there are many “value” and “growth” concepts which are not necessarily consistent. But, overlooking this issue, growth clearly outperformed value over that specific long-term horizon.
However, this time frame "hides" in particular the tech bubble which occurred end of the 1990s beginning of the 2000s. During this bubble, which eventually popped dramatically, value stocks didn't move in extremes.
The current tech rally we are experiencing already started towards the end of 2011. But the worst thing an investor could do is switch from value style to growth style when the stocks are at the highest prices in the growth segment. Today, traders can certainly say that growth and especially tech stock valuations are very high, so…
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The Price Earnings (PE) Ratio
Tech stocks are said to have constantly very high Price/Earnings (PE) ratio… is it so?
First of all, it is again a definition question. What PE are we talking about? It is necessary to distinguish between the trailing PE and the forward PE. Trailing PE takes into account the trailing 12 months earnings per share on the denominator of the ratio, it is therefore looking at past but effective accounting results (these are not an economic perspective). In the case of the forward PE, estimated earnings for the coming 12 months are used. Although it’s forward looking, investors can be assured the numbers will be impacted by forecasting errors.
Which one is more important, trailing or forward PE? That’s very simple to answer, it's the forward looking one since stock prices are only forward looking. Of course, another dimension to consider, the quality of the estimates, depends on the type of activity and the related transparency.
Let’s take the case of the very popular Apple stock:
On the 9th of September 2020, Apple stock’s trailing PE was at about 35 while its forward PE was close to 30. This compares with the NASDAQ’s trailing PE and forward PE of about 26 and 22 respectively and the NASDAQ 100 of the 100 biggest capitalizations that are non-financial which had a trailing PE and forward PE of around 36.5 and 32 respectively. In parallel, the S&P500’s trailing PE and forward PE were about 38 and 25.5 respectively. So, in other words, when traders see the current very strong outperformance of the NASDAQ versus the S&P500, the trailing PE are actually … not that high, surprisingly. Also, the forward PEs are typically (well) lower, implying that the future earnings are currently predicted to be effectively increasing.
Of course, the PE only tells one part of the story and could be misleading in terms of interpretation. Listed companies have also often refrained from providing earnings guidance in relation to the effects of the coronavirus (making it even more a “guessing game”).
Although diversified tech stocks portfolios are most likely attractive in the context of a very long-term horizon – even when compared to value stocks, it's quite a different story when investing in short and somewhat longer-term horizons. A shorter term investment would require investors to consider a (very) active approach. Of course, this alternative investment approach for tech stocks is certainly worth having a look at, which we will cover in further articles.
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