There are signs on the surface that U.S. technology stocks have reached the kind of speculative peaks they did during the late 1990s and in 2021. There are, however, important differences that may allow tech stocks - even those outside of the Magnificent Seven club - to continue to outperform.
Companies with enterprise-value-to-sales ratios greater than 10 times now account for 24 per cent of U.S. equity market capitalization. Goldman Sachs chief U.S. equity strategist David Kostin notes this is not far off the 28 per cent peak in 2021 and 35 per cent in early 2000, before significant downdrafts occurred. High growth-stock valuations are now 1.3 standard deviations above the 40-year average.
The extreme concentration of assets into artificial intelligence-adjacent large-cap tech companies explains a big part of the trend. Mr. Kostin notes that even though the number of companies with high EV/sales ratios has fallen dramatically in the past three years, the stocks that are expensive have become enormously so.
Importantly, Mr. Kostin believes that current megacap tech stocks, unlike those in the 1990s, enjoy fundamentals making them deserving of high valuations. He estimates that the Magnificent Seven stocks are priced for three-year average annual sales growth of 12 per cent - an achievable target. Investors have rewarded the megacaps for maintaining profit margins instead of the “growth at any price” investment strategy during 2021.
The Magnificent Seven stocks are considered high quality because of strong balance sheets, profitability and low debt. Mr. Kostin grants that high-quality stocks in general are two standard deviations expensive versus the 35-year average and that “while valuations are poor signals for [market] timing, it suggests that the potential energy for a reversal is high.”
Goldman Sachs expects continued high borrowing costs to limit upside for smaller companies, as their profits are more negatively affected by higher rates.
If megacap stocks are now too expensive and small-cap stocks hampered by stubbornly persistent inflation, this leaves investors to thread the needle, identifying profitable sectors and companies not in either group. As a start, Mr. Kostin expects asset-heavy sectors like communications (Verizon, T-Mobile) and semiconductors (Micron Technology, Intel) to outperform as inflation expectations slowly decline.
-- Scott Barlow, Globe and Mail market strategist
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The Rundown
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Globe Advisor
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Question: At present the total value of all my portfolios is more than $1-million. I currently have about 60 stock/bond positions. Is this too many to manage? – Gord Z.
Answer: Sixty is a lot. The fact you’re asking the question suggests you feel the same. That’s an average of about $16,700 per position, which is small in a portfolio of that size. If you aimed for 25 positions, the average would be $40,000 each. This strikes me as more manageable, while maintaining good portfolio balance.
You could reduce this even more by using five index ETFs to cover the TSX, S&P 500, Russell 2000, and EAFE, plus the bond market. Then choose 10-15 individual stocks from the U.S. and Canada to target companies you feel have above-average prospects. Portfolio size: 15-20 positions.
Having said this, if you are generating above-average returns and you’re comfortable with the current situation, don’t change.
--Gordon Pape (Send questions to gordonpape@hotmail.com and write Globe Question in the subject line.)
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