The valuation of a growth market (or company) taken to its logical extreme can be almost infinite as the discount rate approaches zero. Of course, in the real world, risk premia do (and should) exist. While market leaders in some sectors have monopoly-like power, growth is eventually constrained by competition, new entrants, market size, regulation and available resources (unless we start trading with Mars). The US Information Technology sector currently trades at 7 times Enterprise Value to Sales (light blue line, chart 1). The ratio is only marginally below the heady days of the 2000 bubble. Of course, interest rates (and the discount rate) are well below the prior episode. The US Fed Funds Rate peaked at 6.5% in June 2000. Nevertheless, the US technology sector valuation is still very heroic despite the low rate and favorable liquidity environment.
To be fair, the compound return on equity (or profitability) for the US technology sector has been more than 21% over the past decade. That has clearly been attractive in a low-trend growth world since the 2008 crisis. Over the past two years, trend return on equity has been even higher at over 30% for the sector and even more for the large mega-cap companies (chart 2). The additional point to note is that the major technology companies have also had strong balance sheets (net cash).
Over the past few weeks there has clearly been a non-trivial (20% or more) correction in some of the most speculative or richly valued companies. While it is tempting to attribute this entirely to a rise in bond yields or market interest rates, it is also possible that the former is a reflection of the stronger macro cycle which favors companies with high operating leverage to the recovery. In the latter regime, investors no longer need to over pay for scarce growth in a secular-stagnating world.
Within our portfolio we have taken a barbell approach with two different equity baskets. The first has a bias toward value, cash flow, dividend growth, balance sheet strength and companies with leverage to the stronger macro cycle. The second is a basket of the major Asian technology companies (with a value filter or overlay). While the Asian technology sector has already performed well over the past 12 months, it still trades at 1.7 times EV/Sales and a 75% discount to US technology. That discount is greater than is warranted based on trend profitability. Of course, the Asian technology sector has more cyclical earnings (57% is semiconductors/hardware) but the majors are intimately linked into the US and global supply chain. Recent regulatory concern and pressure on the Chinese companies has increased the discount and likely presents an opportunity. In the medium term, the major internet stocks in China will probably continue to be a decent way of gaining exposure to the Chinese consumer.
The recent correction in the Asian technology sector has also coincided with the pull back in Chinese equities. Afterall, China represents 40% of MSCI emerging markets which is in turn dominated by technology. As we noted on Friday, the performance of Chinese equities has often been heavily influenced by liquidity as the credit cycle tends to drive the business cycle in China. In turn, liquidity and credit is correlated to risk perceptions or the valuation multiple. The final point to note is that the ebb and flow of liquidity (whether credit is accelerating or decelerating) tends to move inversely to the US dollar (chart 3). Our sense is that the recent reversal of US dollar weakness (Asian currency strength) is temporary, before a renewed phase of dollar depreciation over the coming quarters.
The good news, as we noted above, is that; 1) the Asian technology sector trades at reasonable outright and relative valuations; 2) Asian technology is levered to the cycle which has decent odds of being well above trend; and 3) the sector offers diversification from the US/developed market equity where it is under-represented.
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.