Earlier this month, I asked if mega-cap US tech shares were “imposters” all along.
It wasn’t an especially novel query on my part. Effectively, I was just recapping a thesis espoused by a handful of skeptics who’ve repeatedly argued that some of the best-known growth stocks in the world might be cyclicals in disguise.
If that were true, I wrote, “it was a pretty convincing ruse. And it went on for a long, long time.” My point was that there’s a threshold beyond which claims to prescience are disingenuous.
America’s mega-cap tech champions haven’t looked very “growth-y” lately, that’s for sure (figure below), but rather than assert they were never growth stocks in the first place, it’s probably more apt to suggest they’ve simply run up against the law of diminishing returns. It’s hard to grow once you’re enormous.
In light of that discussion (which was itself prompted by underwhelming quarterly results from Alphabet, Amazon, Meta and Microsoft), and in consideration of the extent to which higher rates (and particularly the drag from rapidly rising US real yields) led to dramatic de-rating across US growth shares, I thought it was worth highlighting fresh commentary from Goldman’s David Kostin who, in his year-ahead outlook for US equities, dedicated a few paragraphs to what he described as “The end of exceptionalism” for mega-cap tech.
Note that I also conjured the “exceptionalism” talking point in the linked article above. US stocks don’t look so exceptional on a five- or 10-year lookback once you strip out the titans.
The figure on the left (below) just shows that the market cap share commanded by Apple, Microsoft, Alphabet and Amazon has declined materially over the past 12 months, in keeping with severe underperformance (1,200bps worth, in fact) versus the S&P 496, if you will.
If today’s leadership is condemned to a fate similar to that suffered by the largest stocks in the S&P during the height of the 90s bull market, there’s a long way down. Naive as this might sound (and probably is), it’s very difficult to imagine Apple, Microsoft, Amazon and Alphabet only comprising 6% of S&P market cap at any point in the foreseeable future.
The figure on the right (above) is, I think, more interesting. “Between 2010 and 2021 the mega-cap tech firms generated very high average annual sales growth of 18% versus just 5% for the broad market,” Kostin observed, before noting that “the dynamic has reversed this year” such that “aggregate sales growth for mega-cap tech is forecast to rise by 8%, well below the 13% growth expected for the overall index.”
That’s remarkable. As is the projected collapse of the overall sales growth premium over the period looking out to 2024. Consensus sees annualized sales growth for Apple, Microsoft, Amazon and Alphabet of 9% over that stretch, not that much better than the rest of the market.
It’s hard to see how this is tenable going forward. Sure, new champions will emerge, but what happens in the interim is up for debate.
“One year ago, we noted that the greatest risk to the leading Tech stocks was the need to maintain their lofty expected sales growth rates,” Kostin went on to write, before drawing the 2000 parallel again. “During the two years following the March 2000 Tech Bubble zenith, the four largest firms at the time collectively posted half the sales growth that had been expected by consensus,” he said. “The group’s relative valuation contraction was dramatic.”
He didn’t mention Meta which, notwithstanding my lottery ticket-style bet on the shares last month, remains on very thin ice.
I am in software, so I am inclined to think in that context, and I view the new champions to be those firms who build software across, or on top of the three big cloud providers. I think of GCP, Azure, AWS as the foundation and firms like Hashicorp and Confluent to be the new titans. For me, it’ll be interesting if some of these cross cloud platform providers get acquired by a particular cloud platform.
H, I can’t believe you didn’t sell your META shares after they popped ~15%.
That 2000 cohort looks awful sans Microsoft. That being said, the current mega-cap titans are on much firmer ground than the 2000 versions. Hard to imagine their dominance of the S&P 500 eroding like the 2000 cohort given that their valuations are based on much stronger cash flows, profits, and market dominance. What percent of S&P 500 profit and cash returned to shareholders comes from those 4 companies (and feel free to throw Meta in there) compared to the 2000 mega-caps?
I’d also argue today’s mega-caps have much larger moats around their businesses. The primary threats come from the other mega-caps, but most of them have failed to make a meaningful dent in each other’s businesses with the exception of Android and Azure.
Lastly, EPS growth will remain strong. Even if cash flows flatten, those buybacks become even more effective when valuations are down. To me, these are great value stocks with growth stock potential at these levels.
Moats, yes but none of these big tech firms can escape their own internal cycles. Even back in the 1960s, when IBM was totally dominant in the computer industry made its living from the gigantic Model 360 in all its versions, the firm’s biggest challenge was how to manage its internal cycles. Innovations make most true tech obsolete in a relatively short time and any tech firm affected by these life cycles has to update. But they still have aging legacy equipment to service and when the new stuff is ready for sale, the old stuff is dead and stops selling. If the transition is somehow mismanaged it can stop the train and cause significant dips in performance. Apple has to fight this, as does Microsoft, Nvidia, Cisco, Intel, Applied Materials, and others of their type. Old codgers like me remember when this problem of cyclicality was called the Osborne Effect because of the existential difficulties it created for the makers of the first true laptop computer. All of tech is cyclical but the cycles are primarily driven by the life cycles of innovations rather than those in the economy.
One other point to remember here is that there is no such thing as the “tech industry.” The word “industry” is defined as a group of similar firms producing goods or services which are close substitutes for the outputs of other industry members. Microsoft is in the software industry, for example. Tech is a word which describes a large sector of the economy and which contains many distinct industries. It is important to remember that the different industries which are part of the tech sector each have their own distinctive behaviors and cycle at different times, driven by the life cycles of their particular businesses. This is not sophistry, it is economics.
Ah, AAPL, the Last FAAMNG Standing. Plugging consensus forecasts and current rF into a basic DCF valuation model suggests that AAPL’s current price discounts terminal growth of almost 6%. Since no company can grow at 6% forever, plug in 2% to 3% which returns valuations something like -30% to -40% down from current price.