Five big tech stocks have accounted for 41 per cent of the S&P 500’s market capitalization advance of this year. Portfolio manager John Stephenson picks two of them, plus a smaller online subscription business that has achieved a level of sustainable scale, growth and profitability that isn’t currently reflected in its stock price, as his best stock buys of the month.
For much of the last decade stock picking has fallen on hard times as passive investing has made huge inroads into the traditional mutual fund business. Firms that try to beat the market have faced pressure in recent years from funds that aim to mimic the performance of the broad market, often at a much lower cost.
But this year, stock pickers are having a much better start, in large part because of the big boost from a select group of big technology stocks. Many stock pickers that have beaten the market in the early months of the year have five of the best-known technology stocks to thank: Facebook Inc. (NASDAQ—FB), Amazon.com (NASDAQ—AMZN), Apple Inc. (NASDAQ—AAPL), Google parent Alphabet Inc. (NASDAQ—GOOGL) and Microsoft Corp. (NASDAQ—MSFT).
These five stocks have accounted for 41 per cent of the S&P 500’s market capitalization advance of this year. The best-performing funds by definition pick the best-performing stocks. While funds in the past have had large holdings of big tech stocks, what’s unusual this year is that the biggest stocks are doing particularly well, meaning investors must make more outsize bets to beat their benchmarks.
The average price gain for the S&P 500’s ten largest US stocks was 12 per cent through the first five months of this year, the second-highest mark for that group over the past two decades. The S&P 500’s tech sector had gained 20 per cent this year through May, compared with the broader index’s 7.7 per cent advance. Facebook, Apple and Amazon have all climbed at least 32 per cent this year through May; Alphabet was up 25 per cent while Microsoft had tacked on 12 per cent.
While technology shares have suffered some recent slumps the sector still is the S&P 500’s best-performing sector year-to-date, rising more than 19 per cent.
Today is different than the dot-com boom
The heady rally in technology and internet stocks is in some ways reminiscent of the dot-com bubble in the late 1990s, when the promise of the information superhighway translated into bullishness that ultimately imploded. But one key difference between then and now is that firms like Amazon and Alphabet are more deeply entwined in the day-to-day lives of their customers; they also enjoy more of an edge over competitors and are expanding into more industries.
By some comparisons, the shares have room to run. Tech stocks were an even bigger proportion of the S&P 500 back in 2000, representing 34.5 per cent of the overall index compared with 23 per cent today, according to S&P Dow Jones Indices. And valuations were higher then. The average stock price of S&P 500 tech shares trade at 19 times the earnings that analysts expect over the next year. That is above the S&P 500 index’s price/earnings ratio of 17.7, but is far below the P/E of 53.4 that the tech sector traded at in March 2000.
Not only is the tech sector a winner in its own right, but Amazon’s $13.7 billion acquisition of Whole Foods (NASDAQ—WFM) is being seen globally as a warning shot to local grocers, further exacerbating the difference between the market’s best-performing stock sector and one of its worst-performing sectors. For a deal centred on 430-some stores based mostly in the US, Amazon’s bid for Whole Foods has spread collateral damage surprisingly far and wide. Shares in Australia’s Woolworths (ASX—WOW) fell 3.5 per cent on the first trading day after the deal was announced. In Europe, shares in Amsterdam-listed Ahold Delhaize (AMS—AD) plunged almost 10 per cent after the deal was announced, while in the UK Tesco’s (LON—TSCO) stock fell 5 per cent. The stocks of box manufacturers, on the other hand, have skyrocketed.
Amazon’s accelerated move into groceries
Amazon’s move into brick-and-mortar grocery operations shows how dramatically a few deep-pocketed tech firms can overnight disrupt the business models of retailers of all stripes. With this move, Amazon has clearly signaled its intent to invest in new growth options more aggressively. Amazon appears to see in Whole Foods an opportunity to accelerate its ramp into an approximately $3 trillion total addressable market for groceries, a market that has been very inefficiently served for decades. Amazon has reasonably well-developed logistics experience in grocery and has achieved decent traction already, having likely generated over $5 billion in groceries sales in 2016. Amazon has always been the company that has benefited from the arbitrage between rising retail costs and declining technology costs.
One of the biggest threats Google, Amazon and Facebook are likely going to have to contend with is new regulations targeting online privacy and the way customer data is collected and used. But while antitrust concerns are a risk, especially in Europe, there is no way to predict their timing or impact.
The other risk is that as the companies expand they will compete with each other as their business models sprawl into new, overlapping industries.
What I Recommend
One company that I really like is Amazon.com, the largest retailer on the Internet and a firm that operates in seven countries, with over 300 million customers worldwide. Amazon’s two key end markets, retail and cloud computing, are still only ten per cent penetrated, offering plenty of room for Amazon to grow. Amazon’s organic year-over-year growth rate has been above 20 per cent for nearly 10 straight years. Amazon has some very deep competitive moats around the firm, and they are deepening. Amazon’s execution is consistently excellent and the company remains arguably the single best play on three of the biggest tech trends today—Cloud, AI and Voice Activated Internet (VAI). I have a ‘buy’ rating and a twelve-month price target of $1,150 USD per share for Amazon.com.
Netflix (NASDAQ—NFLX) is an online entertainment subscription business that has more than 99 million streaming subscribers globally. For an approximate price of $8 to $12 per month (depending on a user’s plan), subscribers receive unlimited access to curated TV shows and movies. The company has achieved a level of sustainable scale, growth and profitability that isn’t currently reflected in its stock price. Netflix is one of the best derivatives off the strong growth in online video viewing and in Internet-connected devices (tablets, smart phones, Internet TVs). The steady expansion in the US contribution margins demonstrates the company’s profitability, with its fixed-cost content nature and historically declining churn rates suggesting further margin expansion. I have a ‘buy’ rating and a twelve-month price target of $185 USD per share for Netflix.
Another name that I really like is Alphabet Inc., a top search destination on the Web and a provider of a leading search-marketing platform for advertisers and merchants. Global Internet advertising spend will be approximately $200 billion in 2017, which makes the Internet a sub-40 per cent media channel in terms of advertising spending on a global basis. And with incremental mobile Internet usage surging, and TV advertising budgets likely beginning to tip online, there is still significant secular growth ahead. Through scale, aggressive product innovation, very substantial investments in capital expenditures ($42 billion over the past five years) and heavy research and development ($33 billion over the past five years), Alphabet has established unusually deep competitive moats around its business. Google has long been the major leader in search advertising, accounting for 70 per cent plus of global search advertising revenue and, at the margin, its market share has continued to expand. I have a ‘buy’ rating and a twelve-month price target of $1150 USD per share on Alphabet Inc.
While the technology stocks’ run so far this year has been impressive, for now at least, it appears as if the strong will continue getting stronger. It looks as if we are going to have a winner-take-all or winner-take-most world. For my money, I wouldn’t be jettisoning your favorite tech stocks anytime soon as few other companies touch peoples’ lives as directly and often as these tech titans.
John Stephenson is an award-winning portfolio manager and the President and CEO of Stephenson & Company Capital Management Inc. in Toronto. He is the author of “The Little Book of Commodity Investing” and “Shell Shocked: How Canadians Can Invest After the Collapse”. He is also the publisher of Strategic Investor (www.StephensonFiles.com). He can be reached at (647) 775-8360 or (844) 208-8817, or firstname.lastname@example.org.
This is an edited version of an article that was originally published for subscribers in the June 2017/Second Report of The MoneyLetter. You can profit from the award-winning advice subscribers receive regularly in The MoneyLetter.
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