“This Time is Different” is an infamous phrase in finance that has historically led to some spectacular results, both positively and negatively. Over the past ten years in the United States, the information technology sector (“TECH”) of the equity market has outperformed all other equity market sectors by a significant margin[1]. For some investors, the valuation of the TECH sector today is reminiscent of the TECH sector of the late 1990s and are worried about history repeating itself. In contrast, other investors highlight that the TECH sector is more mature, with higher margins and more stability. In our opinion, today’s situation has aspects similar to the early 2000s, but today’s situation is different.
Empirically equity market valuations are a useful predictor of expected returns over the next three to five years. However, using valuations without considering the profitability of a business, sector, or market provides only a limited view. Adding profitability metrics, which reflect a company’s ability to generate revenue, cash flow, or earnings, provides a more holistic picture. Said differently, a company that is “cheap” based on a valuation metric may be cheap because the business has deteriorating profits, while a company that is “expensive” based on a valuation metric may be expensive because the business has strong profits. The latter is an example of what is currently occurring in the U.S. information technology equity sector, as seen in the figure below.
Source: Innealta Capital. Valuations refer to the trailing twelve-month price to cash flow ratio. Profitability refers to the return on common equity. TECH refers to the S&P 500 Information Technology Sector Index. “Average (ex TECH)” refers to the simple average of all sectors excluding the Information Technology sector at that point in time. S&P 500 refers to the S&P 500 Index. In September 2016, the Global Industry Classification Standard (“GICS”) elevated the real estate industry group to a sector.
Similar to the early 2000s, the U.S information technology equity sector has elevated valuations relative to other sectors in the S&P 500. Yet, today the magnitude of the valuation difference is less than in the early 2000s. Based on profits, the TECH sector is much more attractive today than in the early 2000s and much more attractive than the other S&P 500 sectors. Do we believe that the current relationship between valuation and profitability is a conundrum facing investors? Yes, everyone would love to invest in a cheap sector showing better profits than the market, but such scenarios are not common. Today, TECH investors must decide whether the profits justify the valuations. In the early 2000s, TECH’s expensive valuations were not supported to by sizable profitability metrics that the sector exhibits today, which gives us confidence the Sector is not approaching the same metaphorical cliff of the early 2000s. In other words, we believe this time is, at the very least, a little different.
This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Innealta Capital, LLC as to its accuracy, completeness or correctness. Innealta Capital, LLC does not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Innealta Capital, LLC has no obligations to update any such information.
[1] Source: Innealta Capital. As of 02/28/2021. S&P 500 Information Technology Select Sector annualized total return was 19.97% from 02/28/2011 to 02/28/2021. The average (simple arithmetic) annualized total return of all other S&P 500 sectors, excluding the Information Technology and Real Estate, was 10.52% from 02/28/2011 to 02/28/2021.
The S&P 500 Information Technology Sector Index is a capitalization-weighted index, composed with those companies included in the S&P 500 that are classified as members of the GICS information technology sector. The S&P 500 Index is a diversified large cap U.S. index that holds companies across all eleven GICS sectors.
727-INN-03/08/2021