In recent years, US Tech stocks have become the darlings of the investment world, driving a significant portion of the S&P 500's impressive performance.

As a former portfolio manager, I often receive questions about whether tech stocks remain a wise investment, especially given their seemingly high valuations.

Tech companies like Apple, Microsoft, and Google have indeed seen their stock prices soar, raising concerns about whether they are becoming too expensive.

However, these same companies continue to deliver exceptional growth and profitability, outpacing the broader market.

This note will provide a balanced perspective on the current state of US Tech stocks, evaluating them through a multi-factor approach that includes valuation, profitability, growth potential, sentiment, and momentum. By examining these factors, we can determine if tech stocks still deserve a place in your portfolio and whether it's time to diversify into other sectors that may be flying under the radar.

Our Approach to Finding Attractive Stocks

We utilize a multi-factor approach to ranking stocks based on valuation, growth, profitability, momentum, and investor sentiment.

Our current universe of companies is comprised of all US-domiciled stocks with market capitalizations greater than $200 million and international stocks with company-sponsored American Depository Receipts (ADRs) trading on US exchanges. Our universe is currently composed of approximately 3000 securities.

Each week we rank all stocks in our universe based on various characteristics within each of the different factor categories of valuation, growth, profitability, momentum, and sentiment.

Some of these characteristics move a lot from week to week such as momentum and sentiment while others such as valuation, growth, and profitability vary a lot less over the short term.

Each category of factors is weighted (within a range) based on their historical ability to distinguish top from bottom-performing stocks.

On average, the weights for each factor category are currently as shown below with ranges within parenthesis.

• Valuation: 25% (20-40%)

• Growth: 20% (10-30%)

• Profitability: 20% (10-30%)

• Momentum: 25% (15-30%)

• Sentiment: 10% (5-15%)

Unlike a lot of other multi-factor models, we do not segregate stocks by sector preferring instead to treat all stocks the same regardless of economic sector or industry.

Note: The higher the score the more attractive the stock.

In the following charts we will use the following mnemonics for each economic sector:

• CD Consumer Discretionary

• CS Consumer Staples

• EN Energy

• FN Financials

• HC Healthcare

• IN Industrials

• IT Information Technology

• MA Materials

• RE Real Estate

• TS Communication Services

• UT Utilities

Let’s take a look at how Tech stocks look based on our various factor categories.

We use median factor scores to reflect the central tendency of stocks in their respective sectors. A median simply placed ½ the sample above the value and ½ below. Medians tend to be more accurate measures of central tendency compared to averages, especially in the presence of outliers.

As such we are mixing large, mid, and small-cap stocks to get a sense of sector attractiveness.

Caveat: Significant factor differences may be present among market cap tiers.

Valuation: Assessing the Price of Tech Stocks

US Tech stocks have undoubtedly been at the forefront of market gains in recent years, but their soaring prices have also sparked debates about their valuation.

Valuation is a critical factor in investment decisions, as it helps investors understand whether a stock is priced fairly relative to its earnings and growth prospects.

Current Valuation Metrics:

• Price-to-Earnings - the most widely used valuation metric

• Price to Cash Flow - similar to P/E but focused on generated cash flow (the idea that all that matters is how much cash a business is generating)

• Enterprise Value to EBITDA (earnings before interest, taxes, depreciation, and amortization) - used in private equity setting to adjust for different levels of indebtedness

• Discounted Cash Flow (Model) Price - based on full modeling of the business and its cost of capital. The most comprehensive measure of value

• Sell-Side Analyst Target Price - the average upside/downside based on analyst target prices

Current Valuations (the higher the better):

High-Level Observations:

• In terms of our combined valuation metrics, Tech stocks (IT) score second worst only behind Real Estate stocks.

• Tech stocks are overvalued relative to the average stock in our universe

Profitability: Tech Stocks' Impressive Earnings

One of the most compelling reasons to consider US Tech stocks as a viable investment option is their impressive profitability.

Unlike many sectors where high growth often comes at the expense of profits, tech companies have generally managed to achieve both.

The sustainability of tech companies' profitability is a factor to consider. These firms are not just profitable today; they have the potential to maintain or even enhance their profitability in the future.

Current Profitability Metrics:

• Net Profit Margin - profits after adjusting for sales/revenue

• Return on Invested Capital - includes all sources of financing to the firm including debt and stock issuance. Ultimately the best reflection of company profitability.

• Return on Shareholder Equity - the most widely used metric by investors. Reflects judicious use of debt on behalf of shareholders.

Current Profitability (the higher the better):

High-Level Observations:

• In terms of our combined profitability metrics, Tech stocks (IT) score fourth from the bottom at this time

• Tech stocks are currently exhibiting slightly lower-than-average levels of profitability

• Caveat: A big reason for this slightly unexpected (low) ranking is the lower profitability of mid and small-cap tech stocks.

Growth Potential: Future Prospects for Tech Giants

One of the most compelling reasons to maintain an investment in US Tech stocks is their impressive growth potential. Unlike many sectors where growth is often slow and incremental, tech companies frequently exhibit rapid and substantial growth driven by continuous innovation and expanding market opportunities.

Tech giants also benefit from their global presence, accessing and growing in international markets. Their ability to penetrate new geographical markets enhances their growth potential.

Current Growth Metrics:

• Earnings Growth - profit rate of growth over the next 2 years

• Sales Growth - revenue growth over the next 2 years

• Long-Term EPS Growth - forecast of long-term (10+ years) earnings growth

Current Growth Potential (the higher the better):

High-Level Observations:

• In terms of our combined growth metrics, Tech stocks (IT) score highest among all sectors

• Tech stocks are currently exhibiting high rates of business growth and are expected to remain high growth business in the long-term

Investor Sentiment: Market Perception

Investor sentiment plays a crucial role in the performance of tech stocks. Understanding these factors can provide valuable insights into the current and future state of the tech sector.

Investor sentiment reflects the overall attitude of investors toward a particular sector or market. Positive sentiment can drive stock prices higher, while negative sentiment can lead to declines. Currently, sentiment towards tech stocks remains relatively positive, although concerns about valuations and potential market corrections are present.

Current Sentiment Metrics:

• Short Ratio - the percentage of a company’s shares that have been lent out to short sellers (the lower the better)

• Up/Down Ratio - the ratio of analyst stock upgrades (say from neutral to buy) over the number of stock downgrades over the last 90 days (the higher the better)

• Mean Analyst Recommendation - the average stock rating (1=strong buy, 5=strong sell) based on all analysts that follow the company (the lower the better)

Current Sentiment (the higher the better):

High-Level Observations:

• In terms of our combined sentiment score, Tech stocks (IT) score second highest among all sectors

• Tech stocks score slightly below Health Care stocks primarily due to the latter group’s higher mean analyst recommendation

• Tech stocks are currently viewed positively by investors (despite elevated valuation metrics)

Price Momentum

Market momentum refers to the tendency of stock prices to continue moving in their current direction. The momentum in tech stocks has been notably strong, contributing significantly to the overall market rally.

For example, tech stocks have led the market rally in recent years, with the NASDAQ-100 index outpacing the broader S&P 500.

In general, the idea is that momentum persists. Strong performers will continue outperforming and stocks with downward price trends will continue to drift even lower.

Current Price Momentum Metrics:

• Trailing 1-year Price Return - the higher the better. A very strong factor well documented in the academic finance literature)

• 1 Month Reversal - stocks with significant outperformance over the last month receive a lower score while stocks that cratered last month get a positive score. Reflects well-known tendencies for stocks to over and under-react.

High-Level Observations (the higher the better):

• In terms of our combined sentiment score, Tech stocks (IT) score fifth highest among all sectors

• The median Tech stock ranks behind Energy, Financial, Industrial, and Material stocks. To a large extent, this is due to the underperformance of small and mid-caps in our universe.

• On an unweighted basis, Tech stocks are currently ranked middle of the pack in terms of price performance

Putting It All Together - Combined Rating

Tech stocks are generally viewed as the drivers of overall stock market returns this year. While many large-cap tech stocks have done extremely well this year (such as Nvidia or Microsoft) there is a lot more nuance to sector investing beyond what you see when looking only at the S&P 500.

Our stock selection model currently ranks tech stocks as a whole 4th from the bottom in terms of attractiveness. This is from an equally weighted perspective mixing large, mid, and small-cap tech stocks.

In next Monday’s note, I will focus exclusively on the mega caps making up the XLK ETF (tech stocks in the S&P 500 weighted by market capitalization).

When looking at the whole tech sector on an equal-weighted basis here’s what stands out.

The Positives:

• Outstanding growth potential

• High sustainable levels of profitability

• Positive investor sentiment (but this can change quickly)

• A big part of market-capitalization indices such as the S&P 500 and Russell 3000

• The artificial intelligence boom has just been borne. Large-cap Tech is ideally positioned to benefit from this innovation trend.

The Negatives:

• Valuations extended beyond current growth and profitability expectations. Many tech stocks will grow into their valuations but there is risk involved in assessing the overall market opportunity.

• Lackluster and oftentimes deteriorating price momentum in mid and small-cap tech stocks

• Positive sentiment is narrowly focused on a small group of large-cap tech names leading to heavy market-cap concentration in a few names

Asset Allocation Performance Review

High-Level Observations:

• All asset allocation portfolios we monitor are up year-to-date with higher-risk portfolios exhibiting commensurate higher returns.

• Conservative portfolios with a heavier allocation to bonds are still recovering from the rise in interest rates starting in 2022.

• Over the last three years, the GF Low-Risk strategy is only up 1.1% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.6%.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities.

• The GF High-Risk strategy is up 3.2% on an annualized pre-cost basis over the last three years. Over the last 5 years, the strategy is up a respectable 7.9%.

• Year to date, commodities have provided a nice boost. A big reason is higher oil prices. Most recently, precious metal prices have joined the party providing a further boost.

• Over the last month, US Large Cap has performed best. Of note, however, is the performance of both Emerging Market Equities and Real Estate.

• Of concern though is the continued poor performance of US Small Cap Equities. Despite favorable valuation conditions and the massive gap in performance between large and small stocks, sentiment on the asset class remains poor.

• Fixed-income strategies are showing signs of rebirth as monetary authorities around the world are loosening policy and inflationary expectations are trending down.

Weekly Performance Attribution

Long-Term Asset Allocation Portfolio Characteristics

Expected Returns: Expect slightly lower than normal equity and bond market returns given valuation conditions

Risk: Diversify with alternative assets, market volatility has been significantly below historical measures

Equity Risk: Asset allocation portfolios are dominated by equity market risk, no different from the past.

A Bit of Wisdom Never Hurts

I recently started playing pickleball. Just don’t ask me to keep score, but it’s been great fun, especially from a social standpoint. I like not having to run as much as in tennis.

What about you? Are you trying something new?

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this blog are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.