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The tech industry has been on an awe-inspiring run for several years now, and the sector’s dominance continues to be at the front of investors’ minds.

Currently, there’s a lot of dialogue surrounding the mega-cap tech stocks, and their overwhelming market power. The top-ten contributors to the Russell 3000 index’s gains this year have effectively all been tech stocks, depending on your classification of Tesla.

The top five highest weighted stocks in the index (i.e., Apple, Amazon, Microsoft, Facebook, and Google) have effectively contributed all 9.4% of the Russell 3000’s gains year-to-date, when netting out the performance of all of the other constituents. The table below lists the top-10 return contributors year-to-date, and while they aren’t all technically classified as Information Technology stocks, they are all generally viewed as tech stocks.

Source: FactSet (01/01/2020 - 08/31/2020).

Tech is certainly driving the market – and we believe this is the result of a confluence of events. First, the largest companies are dominated by tech, so moves in these stocks are naturally going to have an outsized impact. Second, the fundamentals of these stocks are generally considerably superior to the average company. Tech is growing faster and at higher margins, so all else equal, one would expect tech stocks to become larger drivers over time. Third, COVID-19 has been somewhat of a perfect storm for tech demand. Sheltering-in-place has required considerable enterprise and consumer spending on technology for both work and leisure. Lastly, low interest rates are disproportionally benefiting tech stocks as they are long-duration assets.

Looking Closer at Valuations

Although we are finding some limited areas of value in tech right now, in general, it is difficult to find compelling valuations. Absolute valuations are stretched, aided by low interest rates pushing up multiples. On a relative basis, valuations look a little bit more reasonable.

The broader financial market environment is certainly having an impact. Ten-year US Treasuries are yielding less than 1% currently, supporting elevated stock valuation multiples relative to history. We believe it is important to adjust any historical valuation analysis for today’s ultra-low interest rate environment.

Regarding the five mega-cap tech stocks specifically, they are all trading at very reasonable 18x-25x forward cash flow multiples (the S&P 500 is at 22x forward earnings), especially considering that these companies are growing much faster and at higher margins. Additionally, and despite their enormity, their cumulative free cash flow contribution to the indices is proportionally equivalent to their large weightings. We do not see a valuation bubble in these stocks, and we see minimal risk of a stock price ‘crash’ driven by the largest tech companies. Using our primary valuation method, we are finding strategy fits that are between moderately under- to fairly-valued.

We are more concerned about a growing number of individual cases (e.g., Tesla) where valuations are not supported by fundamentals and appear to be entering bubble territory. In particular, many high growth software-as-a-Service (SaaS), eCommerce, and FinTech stocks are trading at sales multiples of 20x to 50x. When we build financial models for these companies, we generally find that these valuations cannot be supported and are probably irrational.

There is clearly a “winners and losers” market in tech. Businesses that are resilient or benefit from the work-from-home situations have discounted a pull-forward of market adoption. eCommerce, SaaS, online education, IT security, gaming, cloud computing, and internet advertising & content are examples of industries that are perceived beneficiaries. Many of the best year-to-date performers have been in these industries. Legacy on-premise technology companies were already perceived as secularly challenged, and the pandemic has only accentuated—we think correctly—this perception, driving further relative underperformance.

In Our Portfolios

In terms of impacts to you and your portfolio, we don’t think the focus should be on predicting what market factors like crowding and narrowness mean for the indices.

Rather, we focus on assembling portfolios of strong strategy fits at attractive valuations. For example, we don’t own certain names just based on their weight. If we don’t feel they have the right underlying fundamentals, we don’t buy them, period. On the other hand, we are willing to own strong companies who fit our strategy, so long as we find them to be attractively valued. We believe the key question is whether current valuations are justified by the fundamentals, and whether those fundamentals will remain robust into the future.

While we are still finding some opportunities at decent valuations, our tech holdings tend to be focused on software, internet services, select areas of eCommerce, and gaming, among others. Still, valuations of tech broadly are not as compelling as they have been, with certain pockets of excess in the highest growth areas. We are currently underweight in the Information Technology sector in domestic, bottom-up client accounts. Additionally, we are positioned such that if there is a sell-off in tech that drives indices lower, our clients are positioned to help mitigate losses.

Trade Relations and Tech

Broader US-China relations have been strained for several years now, and its impact on tech is clearly escalating with Huawei as a key flashpoint. The US has steadily increased pressure on Huawei to the point where the latest actions effectively preclude sales from any non-Chinese semiconductor companies. SMIC, which is China’s largest domestic semiconductor producer (i.e., foundry), is now being targeted as well with a proposed export ban being considered that is reminiscent of the early actions against Huawei.

We’ve discussed internally that a logical, albeit ‘nuclear’ end game would be for the US to ban semiconductor manufacturing equipment sales to China, leaving them effectively unable to build new fabrication facilities. We’ve used the word ‘nuclear’ because such an action would effectively neuter China’s ability to build up a domestic semiconductor industry, a huge strategic impairment. Not a perfect analogy, but it would be strategically similar to OPEC cutting the US off from oil.

Should the US escalate its actions to the point at which the Chinese feel their strategic access to semiconductors is at risk, it is conceivable that could raise the threat of military action. Taiwan Semiconductor Manufacturing Company (TSMC) is of growing strategic importance as the largest semiconductor manufacturer in the world. It’s location in Taiwan accentuates the potential for it to become a flashpoint. Bottom line, it seems the US is likely to keep ratcheting up the pressure on China’s technology capabilities and it’s hard to say where the lines in the sand are drawn.

The stocks we own are relatively isolated from the geopolitical crossfire, and we believe they are strong strategy fits with attractive valuations. There is so much uncertainty right now around the global semiconductor supply chain that we are happily underweight semiconductors in bottom-up client accounts, particularly as we see rising risks of a bifurcating supply chain into a US and allies supply chain versus a China supply chain.

Additionally, certain China-based investments that we still like, such as Tencent and Alibaba, are overwhelmingly Chinese domestic demand-orientated. The US has less avenues and motive to go after them. They also are likely to benefit from the deterioration of US-China relations in that they are Chinese strategic national champions who receive preferential government treatment.

Anti-Trust Speculation

Beyond fundamentals, we are also closely watching ongoing regulatory risks facing the major tech companies. These concerns have been swarming the five mega-cap tech stocks for several years, and the anti-trust fears have only intensified over time.

In 2018, we conducted a lengthy study analyzing nearly 120 years of anti-trust history in technology to better grasp the potential adverse impacts of greater regulatory scrutiny. At the time, our findings were both compelling and counterintuitive.

The prevailing wisdom that regulatory review negatively impacts these companies is not supported by the evidence. As the largest, most dominant companies in their industries, it is natural that they encounter regulatory oversight. Yes, a handful of these regulatory reviews have led to material business impacts, but they are by far the exception and ignore the dozens of cases that amount to little or no business impact. Instead, these companies materially outperformed competitors for years afterwards, underscoring our finding that fundamentals and valuation trump regulatory scrutiny.

Our analysis was completed in the spring of last year, and we have recently gone back and looked at how our findings have held up over the subsequent 2+ years. Unsurprisingly, the largest companies facing anti-trust review today, Google, Microsoft, Amazon and Facebook, have each substantially outperformed over the period.

Source: FactSet (04/18/2018 - 08/31/2020).

While they all were not in the initial study, we view their recent run as further validation of our thesis: Anti-trust scrutiny is an indicator of substantial business model strength and is not an automatically sell signal. For the few materially negative outcomes that have occurred historically, we found three main reoccurring themes: 1) the regulation outcome fundamentally impacts the business model; 2) the stock was substantially over-valued entering into the period of regulatory scrutiny; 3) the future intensity of government oversight materially increased. At this time, we do not see any of the three conditions as having been met, but we continue to keep a watchful eye on risks in the area.

This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. The reader should not assume that investments in the securities identified and discussed were or will be profitable.

The Russell 3000® Index is an unmanaged index that consists of 3,000 of the largest U.S. companies based on total market capitalization. The Index returns are based on a market capitalization-weighted average of relative price changes of the component stocks plus dividends whose reinvestments are compounded daily. The Index returns do not reflect any fees or expenses.

The S&P 500 Index is an unmanaged, capitalization-weighted measure comprised of 500 leading U.S. companies to gauge U.S. large cap equities. The Index returns do not reflect any fees or expenses. Dividends are accounted for on a monthly basis. S&P Dow Jones Indices LLC, a division of S&P Global Inc., is the publisher of various index based data products and services, certain of which have been licensed for use to Manning & Napier. All such content Copyright © 2020 by S&P Dow Jones Indices LLC and/or its affiliates. All rights reserved. Data provided is not a representation or warranty, express or implied, as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or the data included therein.