The mega-cap technology stocks which have driven global markets for years are some of the riskiest investments available because of the expectations being put on them, RWC’s Nick Clay has said.
Facebook, Amazon, Apple, Netflix and Google parent company Alphabet (FAANG) as well as Microsoft, have been some of the highest-retuning companies of the past decade, carving out a bigger and bigger portion of the global market. The FAANGs alone make up 14% of the MSCI World index and 20% of the S&P 500 and Microsoft is currently the largest company in the world.
It is now at a point where investors may feel like they have almost no choice but to own them, the manager said, but noted he would not invest in them, even if they qualified under his TM RWC Global Equity Income’s investment process, which only invests in companies that yield 25% above the world market.
Clay said that while these were undoubtedly great companies, they have become extremely risky investments because of overpriced valuations and the expectations for perfect growth placed on them.
He added that this is repeating lesson in markets that investors have failed to learn. “Even the best companies in the world, when trading on an excessively high valuation, become the riskiest in the world,” because those expectations become “too great to live up to”.
“However good they are, they just cannot deliver,” he said.
Taking Microsoft as an example, Clay said it was priced for “near perfection”. At its current valuation, the company would need to grow by 1.5 times its current size to be worth considering.
Even if it achieved this, without any further uplift in the share price, it would only bring down its valuation to the company's long-term average price-to-earnings multiple of the past 20 years. This is if nothing goes wrong, which Clay said was unlikely.
Valuations are one issue, but the changing political and social sentiment around how these firms operate also creates an uncertain future.
The social and political attitudes towards these companies and concerns about their influence accelerated the past few years with calls for tighter regulation on the social media companies in particular.
Political intervention or increasing tax rates are very likely scenarios but are not being priced in, the manager said. China has already tried to place some restrictions on its own internet-technology names this year, which had negative consequences for the share prices.
The companies also have to contend with the petering out of the pandemic, which accelerated their earnings and growth to even higher levels, but are now being asked to maintain them without that tailwind.
“Investors are asking for perfection”, Clay said, and in such a concentrated number of holdings “we find that can be quite a risky situation for investors to be in”.
For Clay to invest in Microsoft or Apple the companies would have to halve in size, he argued. The manager held Microsoft in the past back when he ran the global equity fund at BNY Mellon in but the investment case for the company today is too risky and does not meet his investment criteria.
That is not to say the fund is completely devoid of technology. Clay clarified that these mismatched expectations are not true for all growth-tech stocks, pointing to Qualcomm, which makes semi-conductors and is part of the 5G rollout.
“It is the preeminent global leader in that technology,” Clay said, but it is being valued for low growth over the next five years.
“When you come back to the expectations for that company, I would rather take on the risk of Qualcomm being able to do better than shrinking for the next five years, given its position and the momentum behind 5G, than taking a bet on Microsoft being able to go to the moon and not do anything different,” he said.
The manager moved the equity fund and team over to the boutique firm last year after 15 years at BNY Mellon to be run under the same process.
However, the first year at RWC has been “difficult”, Clay said because the market has continued to rise and he cannot invest in these “big sex and violence tech stocks”. This has meant the fund has missed out on a major portion of the market returns.
“And there's nothing we can do about that. We can't own those stocks because they don't have a high enough yield,” Clay said.
“So when the market backdrop is like that we’re likely to underperform, which is what we’re doing.”
Indeed, over the past year the fund has made 12.2%, below the average IA Global Equity Income fund, 18%.
Performance of fund vs sector over 1yr
Source: FE Analytics
However, he said that this is what is right for clients, who should also own a growth fund alongside his own to capture different market conditions.