What if mega-cap US tech stocks are actually cheap?

The hell you say!

No, seriously. Think about it. All you have to do is assume sell-side growth forecasts are accurate. What could possibly go wrong?

I’m sorry for the generic sarcasm. It’s a sarcasm kind of day. I set the tone early with “Expensive Observations,” kept it going with “Until Something Breaks” and now I have to see it all the way through.

The accepted narrative says America’s mega-cap growth champions (predominately tech shares or names we associate with tech, even if they aren’t technically classified as such) are expensive, and in some cases grossly so.

One ostensibly foolproof (and also idiot-proof) way to make the point is to simply note that the P/E gap between the so-called “Magnificent 7” and the median is yawning, both on a trailing and forward basis.

The simple figures above, which are familiar to most readers, illustrate the point.

But, as I’m always keen to note, there’s a reason why these stocks trade so damn rich. Everyone who frequents these pages is apprised of how I think about this situation: Do a back-of-the-envelope calculation for how many times you interact with a product or service from Amazon, Apple, Google, Microsoft and Meta in a given month, then scale that up to half of humanity. That’s the reason the stocks are expensive.

There’s nothing profound about the figure below. It’s just a “zoomed” (if you will) look at the evolution of the valuation disparity between mega-cap tech and what’s come to be known as the “S&P 493.”

The implication: Despite a disproportionate de-rating over the last several weeks amid the ongoing rise in US real yields, the titans still trade at a huge valuation premium.

But Goldman offered a more nuanced take in a new note. For one thing, part of the ostensible de-rating comes from the denominator. “While rising rates have weighed on the valuation of the largest stocks, improving consensus earnings estimates have also contributed to P/E compression,” the bank’s Cormac Conners wrote, noting that “since the end of July, analysts have raised their forward 12-month net income estimates 8% for the seven largest tech stocks” compared to just 2% for the rest of the index.

When you consider growth-adjusted valuations, the “expensive” characterization is less compelling. In fact, the stocks may be cheap. “After adjusting for expected long-term earnings growth, the largest tech stocks trade on the cheapest valuation relative to the median stock in over six years,” Conners went on.

The vaunted PEG ratio for the big 7 is 1.3x versus 1.9x for the median S&P 500 stock. That, Conners remarked, is “the largest discount since January 2017 and a level that has been reached only five times in the last decade.”

As the figure on the right shows, mega-tech traded at a sharp PEG premium post-COVID when the “stay-at-home” trade was all the rage and deeply negative real rates drove tech valuations into the stratosphere.

Simple math suggests that if consensus long-term earnings growth estimates are steady, and US mega-tech merely trades back in line with the median relative PEG ratio observed since 2013, the group has 20% upside.

Those of you old enough to remember the dot-com bust will immediately cringe. I’ll be polite while offering a word of caution: Sometimes, long-term growth forecasts prove to be optimistic.

That said, I’d likewise caution against the idea that today’s tech champions are analogous to yesteryear’s benchmark heavyweights, let alone some of the ill-fated names associated with the dot-com debacle. Never in modern history have a group of companies been so synonymous with the human experience as America’s tech companies are today.

Finally, I think it’s worth highlighting Conners’s brief preview of Q3 big-tech earnings in the context of loud calls (most notably from BofA’s Savita Subramanian+) for equal-weighted outperformance. Here, presented without further comment, is that short preview from Goldman’s Conners:

The largest tech stocks have outperformed the equal-weighted S&P 500 in two-thirds of earnings seasons since 2016, typically outperforming by 3pp over the season. Consensus expects the largest tech stocks to significantly outgrow the overall S&P 500 in the upcoming Q3 results. In aggregate, consensus expects sales growth of 11% across the group vs. expected 1% growth for the aggregate S&P 500. Although consensus has set the bar high, the largest tech stocks in aggregate have beaten pre-season consensus sales growth estimates in 81% of quarters since 2016.