You hear everywhere that the Magnificent 7 stocks in particular and technology stocks in general are very expensive and hence that expected returns are low. But is this really the case? Today we discuss iShares Expanded Tech Sector ETF (NYSEARCA:IGM).
IGM offers access to technology stocks and also to technology-like stocks like Meta Platforms (META) and Alphabet (GOOGL). IGM is a relatively cheap way to invest in technology stocks with a sizable exposure to the Magnificent 7.
GICS reclassification 2018
GICS stands for Global Industry Classification Standard and is a four-tiered, hierarchical industry classification system. The four tiers are: Sectors, Industry Groups, Industries and Sub-Industries. GICS is developed by MSCI and S&P Dow Jones Indices and provides investors worldwide with consistent and exhaustive industry definitions.
In 2018 there was a big reshuffle in the GICS classification. The Telecommunication Services Sector was renamed to Communication Services and broadened with Consumer Discretionary companies like Netflix (NFLX) and Comcast (CMCSA). More importantly, the sector was also broadened with Technology companies like Alphabet and Meta Platforms.
As a result, investors who bought a technology ETF no longer invested in big tech companies like Alphabet and Meta Platforms.
iShares Expanded Tech Sector ETF
Luckily for those investors the iShares Expanded Tech Sector ETF expanded its exposure and switched from the S&P North American Technology Sector Index to the S&P North American Expanded Technology Sector Index. IGM hence invests not only in equities from the technology sector but also in technology-related equities from the communication services and the consumer discretionary sector.
Both Alphabet and Meta are amongst the biggest holdings in IGM. Also, Netflix is part of the ETF. Currently, there are no consumer discretionary stocks in the portfolio.
At each quarterly rebalancing the index is weighted by float-adjusted market capitalization. The following diversification rules are applied: the weight of a single company cannot exceed 8.5%. and the aggregate weight of the companies in the index with a weight greater than 4.5% cannot exceed 45%.
The 5 stocks with the biggest weight are part of the so-called Magnificent 7 and together they account for more than 40% of IGM’s portfolio. Tesla (TSLA) and Amazon (AMZN) are not part of IGM’s portfolio.
On an industry level the portfolio composition looks like this:
Technology and Communication Services have been the best-performing equity sectors over the past 12 months.
And when we look through a factor lens, Growth and Quality are the top performers.
You hear everywhere that the magnificent 7 stocks in particular and technology stocks, in general, are very expensive and hence that expected returns are low.
But is this really the case? Howard Marks offers a nice analogy. He recently described the need to own winning stocks if you want to outperform and summed up the situation as follows.
Firstly, “the performance of the equity indices is often dominated by a few stocks or groups of stocks.” So the outperformance of the technology stocks fuelled by the AI boom is not so unusual.
Next, “the gains of the leaders can make them seem expensive, arguing for profit-taking”.
Market watchers indeed do not hesitate to call the Magnificent 7 expensive and even compare their current valuation with those of the Tech Bubble and the Nifty Fifty.
Thirdly, “Human nature – especially the desire to avoid regret – adds to the motivation to sell.” Figure 7 indeed can add to the motivation to sell.
Howard Marks ends with the remark that “by definition if you reduce your holdings of the winners relative to their representation in the indices and these winners continue to outperform, you’ll have a tough time keeping up.”
So the question is: should we sell our technology stocks because of their rich valuation or will they keep outperforming?
Our first remark when we see Figure 6 is that you cannot compare the Magnificent 7 with the average S&P 500 stock. The Magnificent 7 are quality stocks that tend to trade at a premium.
Our first remark when we see Figure 7 is that it uses trailing earnings instead of forward earnings. When we look at forward earnings, the Magnificent 7 trades at a P/E of 29,5 which isn’t that exorbitant.
Quality stocks with strong profit margins and a high return on equity deserve to trade at a premium.
And Technology stocks fit the bill: they have the highest profit margins and return on equity of all equity sectors.
And while the Magnificent 7 is more than 40% of IGM’s portfolio, there are still other and cheaper technology stocks included in IGM.
IGM’s P/E of 21.7 is reasonable compared to the P/E of 19 for the S&P 500.
The Index in Figure 11 is the Morningstar US Tech Index.
Bottom line: valuation is no reason to shed the technology sector in general and IGM in particular.
Besides the valuation is momentum also supportive of IGM. Technology Communication Services stocks are in a strong long-term uptrend.
The same can be said of Growth and Quality stocks.
Will we get a recession in the US? And what impact will that have on the technology growth stocks? During a recession, growth becomes scarce and hence people will be looking to technology stocks for growth. This might support technology stocks.
On the other hand are technology stocks higher beta stocks and if stocks fall due to the recession, high beta stocks might underperform.
The performance of the Magnificent 7 over the past two years shows they are indeed high beta stocks.
The performance of the Magnificent 7 over the past two years also shows that the outperformance of the Magnificent 7 is less outspoken than generally believed.
Technology stocks aren’t extremely expensive. The valuation of IGM is hardly above the one from the S&P 500. Technology stocks deserve to trade at a premium given their quality characteristics. Technology stocks have the highest return on equity and the strongest profit margins of the eleven GICS equity sectors.
Technology stocks are in a strong uptrend and can be expected to outperform if growth becomes scarce during a recession. IGM offers access to those technology stocks and also to technology-like stocks like Meta Platforms and Alphabet.
IGM is a relatively cheap way to invest in technology stocks in general with a sizable exposure to the Magnificent 7 stocks in particular.