Tech stock valuations have surged during the pandemic and are a major constituent of many institutional portfolios. With fears of another dotcom bubble mounting, are schemes adjusting their strategies or could it be different this time?
The surge of retail investment backing Gamestop has raised an unexpected challenge for regulators. While there were concerns about a large group of presumed amateur investors driving up share prices, it seemed difficult to argue that they should not invest in an asset because it had an unrealistic valuation.
After all, valuations across developed equity markets had been stretched for years, and nowhere more so than in the tech sector. While it was perhaps a shock that an ailing video games retailer could reach $500 (£358) a share and a market cap of close to $100bn (£71.6bn), couldn’t the same be argued for some of the biggest large cap growth stocks across the developed world’s equity markets?
To what extent was the behaviour of Reddit’s self- appointed army of “degenerates” any more or less rational than that of Softbank? The Japanese conglomerate, which had snapped up billions of dollars of derivatives, became a key driver of the tech sector’s gold rush at the end of 2020. In December, it sold its positions, having booked close to $3bn (£2.14bn) in losses.
For investors who have been in the market for more than two decades, the combination of investor euphoria and inflated share prices is reminiscent of the tech-bubble at the turn of the century.
There is, however, one crucial difference: in today’s tech surge, the growing dominance of passive investment vehicles in institutional portfolios and a strong focus on market cap benchmarks means that many large pension schemes are more heavily exposed to tech stocks. The question is, are UK schemes concerned about the tech bubble bursting?
Tech stocks were big winners of the Covid pandemic, partly due to unprecedented levels of monetary stimulus and partly fuelled by their perceived resilience to the economic hit of the health crisis. Indeed, the collective value of the five largest stocks in the sector – Facebook, Apple, Amazon, Netflix and Google’s parent company Alphabet – jumped by 50% in the first half of 2020.
But while these companies are labelled technology stocks, they serve different markets, including consumer discretionary, information technology and communications, which means they have different growth drivers.
As share prices have surged, assessing the value of companies with different income models is complex. If they are measured by traditional market metrics, such as a price/earnings ratio, for instance, valuations for the largest tech firms appear stretched.
In the case of Alphabet and Microsoft, the dominant position in stock markets also corresponds to a quasi-monopolistic role in the real economy. In other cases, such as clean energy giant Tesla, the connection between share prices and the real economy appears less tangible.
A market cap of more than $600bn (£429bn) in the case of the clean energy company would amount to selling its cars for $1.25m (£895,000) each, much higher than the £40,000 you can pick one up for. And while Apple continues to remain a popular household brand, its market cap of around $2trn (£1.43trn) is greater than the value of all the listed companies trading in London combined.
What these diverse tech giants have in common is a perceived status as innovators, combined with a belief that they might be more resilient to structural changes in the global economy; a trend which has been accelerated by the Covid pandemic, says Daniel Booth, chief investment officer at Border to Coast. “The relative valuations of growth versus value are quite extreme today. At the beginning of the year we were at the 95th percentile, according to Research Affiliates, and that means the ratio of more expensive growth stocks to cheaper value stocks was more expensive than 95% of the history, and we’re now at a 100%.
“So, the divergence between the expensive stocks and cheap stocks is at record levels,” he adds. “That is partly because of the Covid market environment that has benefited online large cap tech companies and been disadvantageous for cyclical, leveraged value sectors.”
Back to the future
It is no wonder then, that comparisons to the tech bubble in the early 2000s are mounting. Now, just like then, markets are awash with cash thanks to loose monetary policy and investors piling into growth stocks, although the volume of money in circulation has increased dramatically.
There is also a growing speculation on tech IPOs, from DoorDash (a food delivery service) to Airbnb, which are eerily reminiscent of the initial surge in demand for firms like pets.com in the 1990s.
Investors in tech stocks today argue that traditional metrics of valuing stocks, such as earnings per share, are of little use for the tech sector, because they do not accommodate for the strong growth rate and the different markets tech stocks serve.
One sceptic is Kevin Wesbroom, a professional trustee at Capital Cranfield. “I struggle with that argument. In the year 2000, people were saying that you cannot value e-commerce businesses using traditional valuation techniques because they work in a different way. “For people selling cat food with no business model, you need a different approach. At one level that is true and applies today as well, if you take, for example, the rise of online retailers like Amazon. “I buy into that argument to a limited extent but not to the extent that it would be fully justified,” he adds. “For what it is worth, Tesla probably is overvalued.”
Wesbroom admits that traditional metrics such as price/earnings or earnings per share for measuring value have their limits. “You have to be broader in your thinking, you are backing a disruptor in the broadest sense of the word. But does that make it right that Tesla is currently valued more than the nine biggest car manufacturers in the world? That is a huge premium on disruption you are putting out there and the nature of disruption and gifted individuals is that they do not get it right all the time,” he adds.
Nevertheless, there are still significant differences to the situation two decades ago. On the plus side, Apple, Microsoft and Alphabet are more established than the ambitious e-commerce retailers of the 1990s. Today’s tech giants typically rely on a subscription-based earnings model, which has helped them book significant profits in the past year.
Simon Pilcher, USS Investment Management’s chief executive, argues that any comparison to the dotcom bubble is misleading and cautions investors against opting out of all tech exposure. Instead, he believes the merits of tech stocks should be analysed on a case-by-case basis.
“We’re not explicitly saying that those stocks are to be avoided. Amazon, for instance, is likely to continue to benefit structurally from this shift away from physical retailing. And the ability of that business to leverage its dominant position is impressive. “But that is also the area where at some point one would have concerns about whether regulators might start getting concerned about companies exploiting a dominant position,” he adds.
On the downside, the surge in their market cap means that today’s tech giants have also become major index constituents. If Tesla is included, the six largest tech firms now account for around half of the Nasdaq 100’s value and about a fifth of the S&P500.
This in turn means that they feature prominently in the portfolios of many institutional investors who have opted for passive exposure to developed market growth stocks, which is especially the case for defined contribution (DC) funds. The top 10 shareholdings for Nest’s 2040 retirement fund are almost exclusively tech giants, accounting for more than 12% of the fund’s overall equity investments.
They also cover the lion share of Nest’s higher risk fund, which has more than 70% of its portfolio exposed to equities, of which some 13% is with the six largest tech giants. Nest is not the only UK scheme heavy exposed to the tech sector. They also feature heavily in Smart Pension’s default funds and are the top holdings for The People’s Pension’s growth-oriented funds.
Paradoxically, the prominence of tech stocks in default portfolios is partly fuelled by the ambition to implement ESG criteria into portfolios. To reduce their carbon footprint, some DC providers, including Nest, have opted for passive funds with a climate tilt. But by trying to reduce exposure to heavy carbon emitters, they increase their exposure to tech giants with a relatively low carbon footprint.
For Wesbroom, it is important that all elements of ESG funds – environmental, social and governance – are considered. Tesla, for example, might score well on the E side, but perhaps a not as well on governance, while Apple might score poorly on its social standards.
Perhaps the most challenging part of any bubble is that exiting the market too early comes with a price tag. DC funds with heavy exposure to tech have until now fared extremely well. Nest’s flagship 2040 retirement fund, for example, booked an annualised return of 9% during the past year mainly due to its tech exposure, while funds that have opted out of tech have underperformed the benchmark.
One key challenge for investors in this game of musical chairs might be to establish what events could burst the bubble. For Pilcher, regulation and the introduction of anti-trust measures in the US could be a factor to keep an eye on.
“Prices will struggle if we see a combination of regulatory involvement, where hitherto there has been little regulation. “And there is the possibility that we might see anti-trust focus on some of those stocks,” he adds. “If we were to see poor execution, or if we were to see a change in business leadership within some of those sectors. All these factors could affect share prices.”
Deciding when to opt out of tech stocks is a challenge for open defined benefit (DB) schemes which tend to be heavily invested in equities, but often with the benefit of being actively managed. Border to Coast’s Booth acknowledges that the local government scheme pool, which has most of its portfolio invested in shares, has also benefited from the tech surge.
Nevertheless, at the end of 2020 the pool adopted a more cautious stance. “Within our internally managed funds, we are taking profits on outperforming stocks and rotating them back into cheaper stocks,” he says. “As part of that, the scheme has taken profits out of some large cap tech stocks. In contrast, financials could be an area to increase exposure to in 2021.”
This caution is replicated by Local Pensions Partnership (LPP), which has actively underweighted some tech stocks in its £8.26bn global equity fund. While Microsoft still accounts for its largest holding at 3.3%, its most underweight positions are Apple, Amazon and Tesla. As such, the fund has marginally under-performed its benchmark, the MSCI World, during the past two years. A bet that could pay off if the tech bubble were to burst.
While not all investors are convinced that a correction is around the corner, many DC schemes are starting to take a more cautious stance. Anders Lundgren, Nest’s head of public markets and real estate, says that diversification will play a bigger role for Nest. “We have been experiencing very high valuations in some sectors, but this needs to be seen in the context of the unprecedented fiscal and monetary response to the pandemic.
“As developed market equities become more crowded, and given the likelihood that markets will continue to be turbulent, we want to help find areas that can continue to deliver the performance we want. “This includes increasing our exposure in private markets, such as private credit and unlisted infrastructure equity. US infrastructure is set to receive a significant boost under Biden and being able to invest more in green infrastructure should help in the transition towards a low carbon economy. We believe now is the right time to be diversifying into these asset classes,” Lundgren says.
For Nico Aspinall, The People’s Pension’s chief investment officer, it remains important to remember that many tech firms have booked significant profits in the past year. “While the price of tech stocks could currently be inflated, their revenue growth has been impressive during the past year.
Everybody will be watching to see how quickly their profits can maintain pace with expectations and, crucially, whether the Federal Reserve makes significant increases to the discount rate. The current low-rate environment has also supported high valuations. It would be hard to see an upside for these stocks, but that doesn’t mean they will crash in price, suggesting they were in a bubble,” he says.
But Aspinall also stresses that DC schemes have to think beyond a purely market-cap approach. “At The People’s Pension we include an equal-weighting approach for the largest stocks alongside market cap. We expect it to protect us as the rally becomes more diversified and if the froth comes off the top tech stocks.
“We also use factors to diversify by investing in size, which means tilting towards smaller companies, and value, where we tilt towards under-valued stocks. These measures complement factors which might make us more exposed to big tech, such as momentum, when we tilt towards companies with high share price growth. “You cannot get away from the fact that a balanced approach to constructing portfolios and a long-time horizon are key,” he says.