Investors more wary over tech stock run

True believers in the long-running US equity bull market, which has confounded sceptics and sparked worries about another brewing stock market bubble, focus on the leadership by this generation's so-called 'game changers'.

Among the high-profile companies seen redefining their industry are the likes of Amazon and Google as well as Facebook, Netflix, Tesla and various smaller companies at the frontier of hyper growth prospects in biotechnology, social media and the internet.

Trader on the floor of the New York Stock Exchange.
Getty Images
Trader on the floor of the New York Stock Exchange.

The penchant among some investors for the racier side of the market reflects the lacklustre nature of the US economy in recent years. Against the backdrop of less than compelling broad activity, investors have bet big on companies that are growing quickly or, in the case of biotechs, possibly on the cusp of being transformed by developing a cutting-edge drug.

"The market is interested in companies that can grow independently of the economy and they are willing to pay higher multiples for those," says Robert Stimpson at Oak Associates.

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After a notable swoon a few months ago, many of these so-called momentum stocks have rebounded as economic data have been mixed and underlying volatility loitered near a record low, helping propel the broad S&P 500 into uncharted territory.

The Nasdaq biotech index, for example, has risen more than 20 per cent from its April low, while Netflix has rebounded more than 30 per cent from its early May nadir, with Gilead Sciences, Twitter, LinkedIn, Facebook, Amazon and Tesla also recovering in the region of 25 per cent since the spring sell-off.

Such a performance has caught the attention of the Federal Reserve, which warned earlier this month that valuation metrics for smaller firms in the social media and biotechnology industries "do appear substantially stretched" despite a notable downturn in equity prices for such firms early in the year.

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Steve Weeple, senior investment director at Standard Life Investments, says the Fed has raised an important point about the rise in valuations of small companies in social media and biotech; namely the importance of being a diligent stock picker.

"When the success of strong companies filters down to smaller companies in the sector that have not yet delivered, investors need to be wary," says Mr Weeple.

In the case of Facebook, Mr Weeple says they are impressed by the company's ability to monetise its advertising opportunities, without detracting from its social media purpose.

Big earnings results from the likes of Facebook and Gilead last week have only underlined that valuations are secondary for companies at the frontier of growth.

"Relying on valuations as the basis for making a decision about buying companies that are in the process of redefining their industry is not the right approach," says Dan Greenhaus, chief strategist at BTIG. "Investors should gauge their growth prospects. That is the difference between a Tesla and a GE."

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And prospects remain highly appealing on that score.

Adam Parker and his equity team at Morgan Stanley say revenue estimates for the next year suggest technology, internet and software will most likely be the three fastest growing industries in the market.

"So on the one hand managing a portfolio with no exposure to trends like cloud, big data and analytics seems foolhardy. On the other hand, high growth rates in many of these stocks are already implied by today's prices."

The question now is whether these companies can rally further or are poised to consolidate and deliver lower returns, particularly should the economy accelerate above an annualised growth rate of 3 per cent. Under that scenario, investors should rotate away from momentum stocks to cyclicals. However, the economic outlook remains a big wild card.

"There is a legitimate argument that with the end of quantitative easing there will be slower growth," says Mr Stimpson.

"Social media names are all expensive. It is more of an indication of growth companies receiving a premium valuation in periods where growth is harder to come by."

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So long as the economy muddles along and implied volatility as measured by the CBOE's Vix slumbers near a record low, betting on growth stocks and ignoring high valuations appears to have traction as the defining strategy for US equities.

Russ Koesterich, chief investment strategist at BlackRock, says relying on momentum as an investing strategy only works when volatility remains contained. "These stocks can run further, even with stretched valuations, so long as the Vix stays low."

For some investors, however, missing out on the final growth flourish is prudent as they anticipate a strengthening economy.

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Richard Madigan, chief investment officer at JPMorgan Private Bank says it sold out of high-growth momentum stocks at the end of last year in anticipation of a stronger US economy this year.

"A year ago we felt good about high-growth companies as the economy was not expanding quickly. Now the economy is improving and we are not willing to pay a premium for growth stocks."

Mr Koesterich adds: "In a world in which stretched valuations leave stocks dependent on the Fed's cheap money policies and vulnerable to bad news, we'd continue to emphasise a value bias."

— By Michael Mackenzie and Nicole Bullock, Financial Times

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