Tech stocks are, historically, more volatile. Table 1 shows the standard deviations (the typical measure for volatility) for five of the biggest tech stocks compared with those for five large non-tech stocks. The relative standard deviation (also known as the coefficient of variation) for the former group is, on average, more than twice that for the latter group.
That makes sense. Shares of tech companies have outperformed, having led the broader market rally. Statistically, standard deviation is a measure of dispersion from the mean, both positive and negative. In other words, stocks with bigger gains will, by definition, have higher standard deviations.
But even excluding the gains, by measuring the standard deviation of just the negative returns (the harmful volatility or downside deviation), the losses for tech stocks are also more volatile.
Contrary to popular belief, volatility does not reflect a stock’s underlying risks and it is not necessarily bad. This may sound strange, but I like that tech stocks also have higher downside deviation in addition to “good” volatility.
It tells us that while tech stocks have outperformed, there is no irrational exuberance. Investors have, in fact, priced in a healthy dose of scepticism and caution amid higher uncertainties even if they are bullish on their prospects. This is not what we would see if tech stocks were in a bubble state.
This is further verified by the rationality of their relative valuations.
Chart 1 compares the tech companies’ EV/Ebitda and five-year Ebitda growth. The company with the lowest Ebitda growth (Apple) is also the one with the lowest EV/Ebitda, while those with higher growth are trading at higher multiples. In other words, investors are taking into account prospective growth rates and pricing the stocks accordingly.
This also underscores one of our basic investing principles, that is, all companies must be evaluated on their own merits and not be grouped into a pool by sector/industry.
Indeed, there is no real industry characteristic when it comes to tech stocks. Many operate in their own unique space and owing to the network effect, tend to become monopolies. Hence, there are few really comparable companies.
For us, the key to tech stock valuations is their top-line growth and sustainability of margins. Specifically, where they are currently positioned in the business cycle (or S-curve), which, in turn, will help in understanding their future prospects and valuations.
Charts 2 to 6 show the sales growth and Ebitda margins for our selected tech stocks over the past decade.
Sales growth for Apple is the one most noticeably tapering off from the peak. This could explain its relatively lower valuations, which would be based on modest growth expectations even though margins are being sustained.
Both Facebook and Alibaba Group Holding are still registering very strong double-digit sales growth, which is indicative of future growth and therefore, supportive of higher valuations. Plus, Facebook’s margins are expanding on the back of low marginal costs. Alibaba’s margins, too, are holding up well, though off their high.
Meanwhile, Alphabet (the parent company of Google) and Amazon.com have been enjoying resurgent sales growth in the past two years and from higher bases at that. This is positive and would warrant higher valuations.
On the other hand, Amazon has been doing better in terms of growing its margins in recent years (albeit from a much lower base) while Google has been experiencing some pressure. Again, this could explain the valuation disparity between the two tech giants.
In short, growth and margins are a big part of tech stock valuations, but these variables are also the hardest to predict. And that is why tech stocks tend to be more volatile — because of the uncertainties.
While historical numbers provide some guidance as to prospective growth, obviously the past is no guarantee of the future.
There are so many moving parts. Aside from uncertainties within their core businesses, these tech companies also invest billions of dollars into myriad ventures and revolutionary technologies, usually synergistic but often giving little clue as to their monetisation and eventual payoffs. Many of these small bets would likely fizzle out, but a few may yet turn into meaningful winners in the future.
For the average investor, it is next to impossible to quantify the potential demand, pricing power and margins for businesses that are still undergoing such rapid innovation and technology advancements. Frequently, even lawmakers and regulators struggle to catch up, creating more uncertainties in the operating environment surrounding tech companies.
Most of the stocks in my Global Portfolio rebounded after the selloff in the past two weeks. Total portfolio value gained 3.8% in the week of Feb 19, raising cumulative returns since inception to 6.3%.
This portfolio continues to outperform the benchmark MSCI World index, which is now up by 0.9% over the same period.
Next week, we will review the portfolio, the winners and losers and the rationale behind some of our recent decisions.
Tong Kooi Ong is chairman of The Edge Media Group, which owns The Edge Singapore
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
