While fast-growing US tech stocks have been driving returns on the S&P 500 for the past decade, that trend accelerated in 2020 as the pandemic and lockdowns drove demand for digital services. And it was the biggest tech companies that enjoyed the lion’s share of the growth.
At the start of 2020, the five largest companies – Apple, Amazon, Facebook, Microsoft and Alphabet (Google) – made up around 17.5 per cent of the S&P 500 index. That rose to 22 per cent by the end of the year.
This growth means that many investors have a higher concentration of these companies in their portfolio, which could leave them exposed in the case of a significant pullback. Even in a fund tracking a globally diversified equity index like the MSCI All Country World Index – composed of nearly 3,000 large and mid-cap stocks across 50 different countries – these five companies made up nearly 12 per cent of the total weight at the start of January 2021.
In explaining big tech’s outperformance of the broader market in 2020, Ben Barringer, an equity research analyst at Quilter Cheviot, notes that pandemic-driven lockdowns drove demand for tech services. Working from home and e-schooling drove increased spending on cloud services by major corporations and demand for online shopping and other services soared.
“Look at your daily life and how much you use products from these [five] companies. They dominate digital life,” Mr Barringer says.
But these stocks also received a lift in 2020 due to a “scarcity premium for growth”, with many traditional industries sidelined by the pandemic, Mr Barringer says.
That scarcity premium may well be eroded this year as economies normalise. Many traditional sectors will likely witness significant earnings growth in 2021 compared with a weak 2020. “The earnings strength of tech will continue, but I expect it will be slightly diluted on a relative basis by some other sectors this year,” Mr Barringer adds.
If investors rotate from high-quality growth companies towards traditional value stocks, “that rotation can be pretty violent, but it’s very difficult to predict”, Andy Brown, investment director of global equities at Aberdeen Standard Investments, says.
He pushes back against talk about a tech bubble or that these companies are wildly overpriced. “Valuations are not that demanding for a number of these companies. It’s just a fallacy that these companies are egregiously overvalued.”
Indeed, if large cap tech stocks do dip, it’s likely that plenty of investors will see it as a chance to build additional exposure.
A reduction in lockdowns and the normalisation of economic development in 2021 should cause tech stocks to initially underperform, Patrik Lang, head of equity and strategy research at Julius Baer, says.
“However, in our view, this would be a buying opportunity for long-term investors. As soon as the normalisation of the economic development has been completed, growth stocks are likely to become the focus of investors again, because technology stocks continue to show above-average structural earnings growth,” he adds.
The other significant headwind for many of these companies is scrutiny from regulators over practices seen as monopolistic. While Microsoft had its tussle with the US Justice Department some 20 years ago, Google, Amazon, Facebook and Apple are all in the firing line.
Of the four, Google is the only one being sued by the US Justice Department for violating antitrust laws. Amazon, meanwhile, faces a host of questions in the US and the European Union over its pricing practices and use of data, including to compete against merchants with its own in-house products. Apple’s App Store commission rates are under scrutiny and Facebook has long-running questions about its privacy policies and its acquisitions of Instagram and WhatsApp.
Analysts say it’s hard to gauge exactly how these investigations will impact business – or stock prices – and it’s unlikely that the market will get any kind of definitive answer in 2021.
Penalties in the form of fines are likely to be water off a duck's back, given these company's high profit margins.
“What I would be more concerned about is [an outcome] changing the business model, where you’re fundamentally changing the unit economics or the way that one of these businesses operates,” Mr Barringer says.
“The devil will very much be in the details”, he says, pointing out that while regulations are slow moving, the businesses themselves are fast-moving. “It’s a long-term game that the stock market is trying to price very quickly.”
One immediate impact is that it will be harder for these companies to make new acquisitions of smaller companies, something that could impact their growth and make it harder to respond to new market sectors, Mr Brown says.
But the pushback by regulators illustrates why investors are bullish on many of these stocks, namely that they hold a dominant position in fast-growing technology sectors, believes Alex Gemici, chief executive and chairman of Greenstone Equity Partners.
He views these companies as essentially monopolistic, but believes it’s unlikely they will be broken up any time soon, or if there is a break-up – say AWS being split from Amazon – it won’t affect core business growth.
“When you have monopolies, they get stronger and stronger over time,” Mr Gemici says. “[Many of these big cap technology] stocks are a safe investment with a good probability of high returns – as far as anything is in investing.”
Apple – Has its growth peaked?
While Apple was the first company in the world to reach a $2 trillion valuation, doubling since 2018, analysts believe that its growth could be peaking. Of the five largest companies, Apple is the one they are least keen on, Mr Barringer says.
As a hardware company, it’s dependent on replacement cycles. Sales of its flagship iPhone product make up slightly more than half of its total revenue, but the smartphone market is increasingly saturated. And while Apple has seen strong growth in its services division, including apps on its App Store, continued growth also relies on growing their handset user base, he adds.
Apple is set to get a boost from its rollout of 5G smartphones, but this is already priced into the market, Mr Brown says. Following the 5G rollout, “the market will start asking, ‘Well what comes next?’” he says. “The company is pretty well understood by the market, and it's very difficult to see a lot of upside from here.”
While there are hints that Apple is working on an electric car, it remains to be proven whether it can compete in this market, he adds.
Nevertheless, Apple has surprised investors many times before. “What I think that the market got wrong about Apple in the past was the strength of the ecosystem, which it has built through its operating system and its software,” Mr Brown says.
Facebook – Strong earnings growth likely
A company that everyone loves to hate, Facebook’s fundamentals are strong, with high and growing numbers of daily users, says Mr Barringer. “Regardless of whether you’re a fan of Facebook or not, you are probably using their products” – whether it’s Facebook, Instagram or WhatsApp, he notes. The platform is expected to continue to add new users and is a cheap and powerful way for companies to advertise to consumers, he says.
However, negative press around data and privacy weighs on Facebook and causes its stock to trade at a lower valuation due to regulatory risks, he says. “That discount will remain, but the earnings growth will continue to be quite strong for the business.”
One risk for Facebook is growing competition, with the barriers to entry in social media lower than in some other tech sectors, and with consumer preferences shown to be relatively transient, says Mr Brown.
“We’ve seen other platforms like TikTok rising over the last couple of years and becoming more popular with the younger generation particularly, and it’s one of the reasons we don't own the company in our [Global Innovation Equity Fund] portfolio.”
Amazon – Ample scope for revenue growth
With surging demand for online shopping, Amazon has seen strong growth last year. It hasn't peaked yet, though, Mr Brown says.
Within the retail sector, there’s still a number of categories it can improve, while its cloud computing subsidiary Amazon Web Services remains relatively nascent in terms of the opportunity and the addressable market, he adds.
The company also has a visionary management team and has managed to retain its culture of entrepreneurship and commerciality. “That is very rare, and it’s really important to understand the long-term opportunity for a company such as Amazon,” he says.
Alphabet – More digital ad spend is a win-win
While spending on digital advertisements dropped heavily in March 2020, it also bounced back quickly, benefiting Google and Facebook, Mr Barringer says. Lower costs to advertise also drew in new customers.
Looking forward, there are opportunities for Alphabet's Google and YouTube to grow their revenue as more traditional advertising spend converts to digital, Mr Brown says.
Alphabet also has investments in other areas, including self-driving cars, healthcare and in the cloud, where it remains the number three platform provider (behind AWS and Microsoft).
However, there are question marks for Alphabet, according to Mr Brown. “Will it retain its entrepreneurial spirit and culture? Will people still want to work there? And how do they make sure that transition to becoming a big tech behemoth doesn’t harm the brand with consumers, and they remain a good corporate citizen? These are the sorts of questions which we think are pertinent for companies like Google.”
Microsoft – A great Wall Street comeback story
Microsoft is one of the great comeback stories of Wall Street, with its stock price soaring in recent years, and has emerged as a major player in cloud services with its Azure platform.
Satya Nadella, its chief executive, is a “true visionary” and has made Microsoft once again a popular place to work, which is essential in a talent-based industry such as IT, Mr Brown says.
Offering the full stack of software infrastructure, the company has become the go-to player, especially for large enterprise clients, he adds.
“We continue to see a strong opportunity for gross margins to improve over the next few years, as they start to utilise the asset base they’ve built [by] investing in their data centre footprint,” he says.
