Markets are like teenagers — temperamental and easily bored. They love a “new thing”.
This year’s equity markets have seen most stock prices fall, but a tiny number rise impressively — mainly the technology companies that dominate the global index. The valuation of some of these companies is now far removed from that of other stocks.
Take, for example, Apple, which alone represents 5.2 per cent of the global index (and is up 43 per cent so far this year). A common measure for valuing a company is the ratio of its share price to earnings — the “PE ratio”. Apple’s PE ratio is 29x. It offers a dividend yield of 0.6 per cent and is expected to grow its earnings by 8.8 per cent next year.
In comparison, the whole of the UK equity market represents just 3.9 per cent of the global index. Its price/earnings ratio is 10x. It offers a dividend yield of 4 per cent and is expected to increase earnings by 7 per cent next year.
The excitement of technology companies comes from their “new things” bringing higher sales growth. Apple may have the iPhone 15, a new watch and AirPods but analysts expect just 6 per cent sales growth next year. Against this is the risk that Beijing broadens its campaign to drive Chinese consumers to buy local smartphones instead.
What about other tech stocks? Microsoft sales are expected to grow at twice the rate of Apple’s and its earnings to grow by 12 per cent next year. Based on these forward earnings, the company has a PE ratio of 28x, which seems fair, even if the share price has risen nearly 40 per cent this year. Microsoft looks well positioned for growth in artificial intelligence (AI), both in its software applications and its web hosting business. However, it is in a fight with US tax authorities, which are demanding $28.9bn in back taxes. This will probably hang over the shares.
Alphabet (Google) sales are not expected to grow this year due partly to the strong US dollar, which makes its overseas revenues worth less, and lower US advertising revenue. Earnings, however, continue to grow as it has cut costs, including axing 12,000 jobs this year. The PE ratio at 24x is only modestly higher than the S&P 500 US index average of 17x.
And now we come to the more excitable stocks! Nvidia is now the world’s fifth-largest company, valued at $1.2tn after its share price rose by over 300 per cent in a year. Its sales are expected to double next year and earnings to rise 3.5-fold, leaving it on a PE of 40. Expensive, but it does have a compelling growth story thanks to its powerful processors and the growth of AI.
Amazon — up 53 per cent this year — also benefits from the AI story on its AWS cloud computing business (around a third of the company) but is defending its core online shopping business from an antitrust probe. The company’s sales are expected to grow by 11 per cent this year, which is only modestly ahead of inflation, but earnings should rise more than threefold as the company controls costs. It has laid off 9,000 staff. However, even this jump in earnings only brings the PE down to 57x next year.
Tesla (up 143 per cent this year) is another with a fan club that seems unconcerned about its valuation. Sales this year should rise over 20 per cent. But growing price competition from Chinese automakers and, increasingly, from major players in Japan and Germany means its earnings are expected to fall, leaving it on a PE over 70x, which seems flighty.
Lastly, Meta — the company formerly known as Facebook. Its share price is up 162 per cent this year. Retreating a little perhaps from its metaverse enthusiasm, its sales should grow over 14 per cent and earnings by more than 30 per cent, leaving it on a PE of only 22x. It has a good claim to be well positioned in AI given its large language model, LLaMa. Suggestions that it might offer advertising slots on WhatsApp could boost revenues as this popular service is currently contributing little to shareholder value.
Turkeys and hype
The metaverse is a good example of technology that looks like a turkey — at least in the short and medium term. The past couple of decades have seen plenty of these. Remember 3D television, Palm Pilots, MySpace and Google glasses?
How much money did anyone make from the internet of things (IoT)? How many people ever connected their new fridge to their WiFi to scan food in and out and reorder? Investment funds were created on the back of this that have quietly disappeared. IoT offers a good parallel for the current AI enthusiasm.
It is not that it did not happen, just not to the extent that was hyped. People did not find the new functions that useful and so, after a period of companies putting more chips in things, no extra pricing could be justified by the upgrade.
I suspect I am not alone in seeking out consumer products with fewer gizmos. This is not just because I am getting older and set in my ways, or that I am too lazy to read all the instructions (though I admit it might be partly that). Largely, though, it is because the unnecessary gizmo is the bit that most often breaks, making the whole thing malfunction.
Bursting bubbles
Sometimes the technology does work — think digital cameras. But there are so many players in the field that the profits are minimal.
And sometimes it is just too early to see who is going to win and who will lose. No one can seriously doubt that the internet has changed our lives, but the dotcom bubble and crash in the late 1990s reminds us that enthusiasm can outpace reward.
So how should investors view the AI “new thing”? It seems clear that AI applications will be widespread and enhance productivity. They will dramatically affect sectors that rely on processing large amounts of data, from factory automation to journalism. Doubtless, most companies will look for ways to harness the potential of AI in their businesses. As ever, the discovery of gold will accelerate sales of shovels — the shovel maker for AI being Nvidia chips and related cloud computing stocks.
However, the market value of AI in the long run will be related to the actual consumer benefit from the applications and the realised productivity improvements.
History teaches us that it is not worth betting the farm on hyped stocks at spicy valuations. And especially not in the current environment, where inflation and high interest rates mean the bar has been lifted on how much an equity should deliver to justify investment.
If you are buying tech stocks today, be wary of paying silly prices. Even good companies can be turkeys in your portfolio if you pay too much.
The author is a former fund manager
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