Our friend and partner Charles Trafton of FlowPoint Capital recently pointed out to us some very interesting data: right now growth rates for 2017 EPS are higher for value stocks than growth stocks. He also notes, ironically, that there is no manual for this.
He’s right. There is no manual for much of what we’ve seen lately, and that is precisely the point. The makeup of the market has changed dramatically in the last ten years, with significant new earnings drivers and business models appearing. The distinction between value and growth might indeed be blurring (perhaps permanently) and investors need to adjust and rethink portfolio construction. As always, it’s never a mistake to focus on earnings quality first, regardless of its source.
For example, a frequent lament today is that the market’s valuation, excluding tech and financials, is stretched. To which we would say: then own more tech. Any review of the market’s earnings stream today shows the importance of tech and why that is now a good thing, indeed almost necessary. As you can see from the table below provided by FlowPoint, tech makes up 22% of the S&P’s market cap but contributes 32% of its operating margin.
Today’s tech sector isn’t your father’s Oldsmobile, as we point out here. Tech earnings in 1999-2000, when the sector was 34% of the S&P’s market cap, were of a markedly lower quality. Dirty would be a charitable characterization. The old days of tech had companies doing things like trading network capacity between each other and recording it as revenue, and hiding the impact of stock options on earnings.
Today? Tech provides 38% of the S&P’s total Return on Assets, almost twice the contribution from the next most efficient sector, healthcare, which speaks to the quality of tech earnings now. Look at it selectively and the importance of tech’s earnings quality, and the efficiency of tech business models, becomes obvious. Apple’s return on assets is 14.29% currently, it levers those assets 2.5 times, for a return on equity of 35.0%. Apple’s weighted average cost of capital (WACC) is 11.0%. AAPL’s ROE is three-times its WACC. Now that is whack. We’re not saying AAPL is a buy here (we sold ours last month), only that its business model efficiencies produce a lot of operating leverage, as do most tech franchises.
What about tech companies that masquerade as financials, like MKTX? Right now, its ROA is 28.4% (only 3 cos in S&P 500 have a higher ROA–Altria, ebay and MasterCard) and it is levered only 1.1 times for a return on equity of 31.3% vs. its 10.3% WACC. Put another way, that’s $370,000 in after tax net income/employee. These “tech” companies, especially non-tech tech like MKTX are all extremely efficient. A reason that NVDA is trading where it is, is this (among other good reasons).
It’s precisely because of what is occurring with respect to other sector’s earnings trends that tech becomes such an important pillar, and why investors need to rethink portfolio construction. Look at the chart provided by FlowPoint below. Six sectors of the S&P currently are contributing nothing to the S&P’s return on assets. By nothing we mean zero.
What’s most worrisome to us with respect to earnings are trends like the Amazoning of the consumer space. While Amazon hasn’t eaten the whole world yet, it is a massive deflationary force in a big space that right now contributes positively to the market’s return on assets and earnings growth. Amazon’s impact on retail recently has garnered headlines, and rightly so, but the real impact of the Amazon trend has yet to be truly felt. To us, this is a great risk today, that sectors become zero-sum games. If so, portfolio concentrations to the winners have to increase.
Is it any wonder then why tech stocks have become such core holdings for many? While tech is very much a crowded trade today, which creates its own risks, it is also a trade that appears to be selectively justified. The remaining question is will the other important market sectors make increasing contributions or not, and if not, are they worth owning at all?
The recent CCAR findings appear to indicate that banks will no longer be the drag or the concern they once were, so financials (at least the right ones) could start to help tech shore up the market’s earnings profile. What about energy? Historically it was a big driver of earnings but the current Administration is more likely than not to unleash a production boom (more on that in another blog post) that will act as yet another broad deflationary force. We have pointed out elsewhere what a train wreck consumer has been. Is that ever righted? Materials will always be a sector that responds to macro influences selectively, and should be played accordingly.
So, actively tilting portfolios toward higher quality earnings streams – sustainable, durable business models – will become more important if these earnings trends continue, as they seemingly are. Almost half of the names in the S&P posted negative returns for the past six months. The market is beginning to make distinctions between business models, as we have pointed out before, and so, then, should investors also address the real issue: not just the absolute level of earnings and valuation, but also the quality of the drivers, and who is driving. The evidence would suggest that greater concentrations around higher quality earnings streams is the better approach. We might be at the point where sector diversification is not the risk management tool it once was.