| Summary |
| Technology stocks are on fire, as is normal at this stage of the economy |
| Corporations are not underinvesting, as some people may lead you to believe |
| Long-term investment growth is tied to productivity, but in the short-term it may be a contrary indicator |
| The dominant tech companies may be solidifying their positions and reducing their “extra” investment expenditures |
| Gains from productivity have boosted corporate profitability, perhaps at the expense of workers |
| Long-term, productivity is tied to wage growth, and low productivity growth helps explain why wage growth is subdued |
| Moderation is the way to go. Tech firms with moderate growth expenditures, profitability, and valuation perform best |
Introduction.
.
Technology stocks have been on fire and the FAANGs stocks are constantly in the news. Thus, in this piece of Coach Investing, I thought readers may enjoy a macro review of the technology sector and trends in overall investment spending.
.
Given the hoopla over the FAANG stocks, some may believe that a winning investing strategy in technology may be different today than in the past, but after analyzing a myriad of variables from profitability to uses of capital to valuation to market cap, it appears that a successful investing strategy has not changed much since at least the early 1990s. Namely, moderation is best. The moderately valued and profitable companies that do not over- or under-invest tend to outperform. Large companies also perform best.
.
This got me thinking… Is the talk of increased regulation in the technology sector reasonable? It could be if large technology firms, as they become bigger, have a disincentive to invest and limit R&D and capital spending to the detriment of consumers. Historically, technology stocks tend to spend more, or “extra,” on R&D as a percent of all R&D than their sales and market cap shares are as a percent of all companies. R&D investment may have fueled their past growth, and the growth of the overall economy, as investment in R&D (i.e., technology) may lead to productivity gains. However, since 2011, the market cap share of technology stocks is up compared to all stocks, but their “extra” share of R&D spending has declined. Plus, the FAANG stocks underspend on “extra” R&D than other technology companies; although, they spend more “extra” on cap ex. Furthermore, quintile turnover of technology stocks based on sales growth and ROE has declined, which means the dominant and the weak tech stocks are more likely to stay that way, so the dominant could start behaving like monopolies.
.
This got me thinking… The CEO of BlackRock, the largest investment firm, claims that companies are underinvesting and caving into short-term pressures. In his 2016 annual letter, he notes, “Too many companies and governments have prioritized short-term profits over investments in capital goods, infrastructure, and sensible retirement systems, threatening long-term value creation and economic prosperity.” In 2017, he said, “Without a sense of purpose, no company, either public or private, can achieve its full potential. It will ultimately lose the license to operate from key stakeholders. It will succumb to short-term pressures to distribute earnings, and, in the process, sacrifice investments in employee development, innovation, and capital expenditures that are necessary for long-term growth.” Could underinvestment be the cause of recent low productivity growth? My past research shows that firms tend to invest the most at the end of cycles when cash flow is high, which propels fundamentals even higher before perhaps debt-fueled overinvesting leads to a recession, and therefore, propels the deterioration even deeper. Thus, overinvestment also has its ills. I set out to test Larry Fink’s claim about underinvestment and prove me wrong.
.
We are both right. While cap ex is a contrary indicator over a year or two, there is a positive relationship between long-term cap ex accumulation (as a percent of GDP) and productivity. However, Larry is incorrect that corporations are underinvesting. Most people point out that capital investment as a percent of sales or GDP is not high versus the past, but they fail to consider that firms are spending more on R&D than in the past and R&D plus cap ex (as a percent of sales) is not low. Also, one needs to inflation adjust investment spending when comparing it to productivity (which is inflation-adjusted). Doing so and you will see that overall spending is nearing a high. Furthermore, lower capital investment makes sense as the service economy has become more dominant in the US.
.
This got me thinking… If overall spending is not low, why is productivity still low? Perhaps this spending is not being used to make more stuff (the numerator in the productivity equation). Maybe R&D today is just to replace old stuff or to disrupt competitors. The economy has also changed and is more service oriented which may negatively impact productivity growth. Productivity is also cyclical, and it slows as capital utilization rises (it has risen). Furthermore, the current moderate to high levels of investment also take time to pay off.
.
This got me thinking… Productivity is quite important for multiple reasons. First, it is a key component of GDP growth (productivity growth, worker hours growth, and inflation drive GDP growth). Second, without productivity growth, workers cannot as easily demand higher wages which leads to an improved standard of living. The market is quite concerned about potentially rising inflation that will cause the Fed to raise rates quick enough to bring forward the next recession, and pundits, strategists, and others have been dumbfounded by why wage inflation has been tamed in the face of a tightening labor market. As shown in an earlier Coach Investing piece, there is a positive relationship between wage growth and inflation. I present an argument here about wages that others have seemed to have missed. Perhaps the best reason for low wage growth is recent low productivity growth. There is a very strong relationship between five-year wage growth and five-year productivity growth.
..
And finally, this got me thinking about profit margins… Profit margins have risen over the long-term as productivity has grown faster than wages, interest costs have fallen, and as tax rates declined. Capital costs have grown while labor costs have fallen as a percent of gross value added by the corporate sector. Will this trend continue in an economy that is dominated more by services? While tax rates just got lower, could interest costs rise?
.
I started to think some more, but I guess I will save those thoughts for another Coach Investing piece since there is much already to share here!
.
Technology Stocks Normally Lead During Rising Markets
.
Technology stocks have outperformed the market over the last couple years. Tech outperformed by 42.4% over the last two years and 8.8% YTD (through May 11, figure 1).
.
.
However, this is not surprising given underlying fundamentals of the sector and economy. Technology earnings growth has been stellar (expected +21% in 2018 after +20% in 2017 versus 21% and 12% for the S&P 500 using four quarter sums of EPS) (figure 2), estimates have been rising (figures 4-6, figure 5 shows the annual revision versus return over the last 12 years), and the sector has experienced strong earnings surprises (figure 7). Technology has growth and cyclical characteristics, with the latter helping lift sales during a strong economy. The sector tends to have a high beta, so as the economy lifts the market it has an even greater impact on the sector. Figure 3 shows that technology (i.e., IT in table) tends to outperform in 70% of rising markets, but in only 45% of declining markets.
.
.
Large Cap Technology Outperforms Small Cap
.
FAANG stocks – Facebook, Amazon, Apple, Netflix, and Google – have been leading the market higher. This is not a new phenomenon as it is not unusual for large tech companies to outperform smaller firms. Going back to 1993, large market cap (top 1/5) tech has outperformed small cap (bottom 1/5) by about 5% per year and 15% over three-year periods. Plus, the gap has widened since the peak of the financial bubble in 2006 to 7% over one-year and 21% over three-year periods (figures 8-10). Part of the widening gap is due to the recent small cap underperformance versus large cap for the overall market; however, large cap’s return advantage in technology is still higher than the overall market.
.
.
Many people are enamored by the glamour of small start-up tech companies that seemingly have a high potential for growth. While they have higher potential for really high returns, they also have much more likelihood of low returns (figures 11-12). Outperformance of large-cap tech companies may be due to their profitability advantage (higher margins) and above average sales growth (figure 13). The margin advantage also gives them a cost of capital advantage as it drives up multiples (figure 14).
.
.
Large Cap Technology Dominates, and Its Advantage is Growing
..
Large cap technology companies dominate smaller cap, and their advantage is growing. This is perhaps the concern of regulators. Figure 15 shows how margins for large cap tech has recently been rising while small cap levels of unprofitability have been getting worse. In addition to superior margins, large cap companies also have higher growth (figure 13). Perhaps alarming to regulators, the likelihood of small caps succeeding, and large caps faltering, has declined. Figures 16 and 17 show that likelihood of turnover, based on separation of technology stocks into sales growth and ROE quintiles, is declining. Although, declining turnover for sales growth quintiles is not unique to technology, as the same trend holds for the overall market (on average). However, overall market’s turnover for ROE quintiles is about the same now as it has averaged since 2003 and the recent trend is upwards after years of declines. Perhaps this is due to disruptions from technology investments?
.
.
Concern with Monopolies are Appropriate if They Harm Consumers
.
Declining turnover, more concentrated profits, and monopoly power are a concern if it harms consumers. Large technology’s percent of the overall technology market cap and sales are about average since 2003 (figure 18); however, its percent of R&D and cap ex has declined (figure 19). With this being said, the technology sector still spends more on cap ex and R&D than its percent of sales (figures 20-22) (i.e., “extra” spending) versus the overall universe of companies. Will these tech companies eventually become so dominant and secure in their positioning that they no longer need this rapid investment spending? Or, perhaps their investments in the past have finally paid off so they need to spend less to support current sales and new growth; in other words, have they achieved economies of scale and benefit from operating leverage and rising incremental margins (i.e., an incremental dollar in sales requires lower expense growth than in the past)?
.
.
Technology (with Amazon) has been growing as a percent of sales and market cap compared to all US companies (figure 20) – they have become more important to the US economy. Technology’s cap ex is also rising as a percent of the total; however, technology’s R&D share has declined since 2011 (figure 21). Figure 22 compares technology’s percent of all companies’ cap ex and R&D to its percent of overall company sales to see how much “extra” it has been spending (perhaps to boost future productivity and sales). As you can see, technology’s share of “extra” R&D spend is down, while cap ex is just catching up with is sales share. This is at least partly due to the growing influence of the FAANG stocks. While FAANG stocks are increasing their shares of cap ex and R&D compared to their share of sales (figure 25), their extra R&D spending compared to other technology stocks is quite low (5.3% extra for FAANG vs 12.5% extra for technology with Amazon included).
.
.
In conclusion, one cannot say that technology underinvests versus other firms; however, its share of investment is declining relative to its sales, and the decline, as far as R&D, has been very significant since 2011. This is at least partly explained by the fact that investment is relatively light for FAANG companies that have become more dominant in the technology sector. More than 100% of the increase in technology’s sales and market cap share gains versus the universe of stocks since 2011 were due to FAANG’s gains (FAANG sales rose from 1.9% of the universe at the end of 2010 to 7.1% now, and its market cap rose from 5.9% to 17.3%) (figure 23).
.
Investment, Productivity, GDP Growth, Wages, and Profitability
.
Lack of Investment is a Myth
.
While the technology sector’s “extra” spending is down, many people’s claim that companies are underinvesting, and that lower investment is leading to lower productivity and GDP growth, is inaccurate. They miss many critical considerations.
.
.
First, while investment in residential and non-residential structures has declined as a percent of GDP (figure 26), it has been replaced with other investments in technology, etc. (figure 27). Overall investment as a percent of GDP is about average; albeit, down since 2013 (figures 27 and 28). However, high levels of investment tend to precede major economic peaks (figures 28 and 32), so moderate investment spending is a good, not a bad, sign. A period of overinvestment may make the economy too hot, investment may be funded by debt, etc., and eventually this overinvestment needs to be normalized by a period of underinvestment that can contribute to recessions or slow recoveries. As noted above, overall investment spending has moved from capital spending to R&D. Figure 29 shows cap ex spending and R&D growth for the S&P 500 over the last 40 quarters and figure 30 shows the combined cap ex and R&D spending as a percent of sales and assets (excluding cash and short-term marketable securities). As you can see, R&D spending has been growing about 10% for 30+ quarters, and cap ex is coming back. Overall spending is near highs as a percent of sales and assets ex cash.
.
.
The economy has become less capital intensive as it has moved from a manufacturing to a service economy (figure 31). A service economy does not need manufacturing plants. The economy is becoming more asset light than it was in the past. Thus, the fact that overall investment spending, in the face of a lower need for capital spending, is moderate (versus GDP) suggests that overall spending levels are pretty strong. This has probably benefited the technology sector.
.
Finally, some people may claim that the slowing annual growth rate in gross private investment (non-residential) is a reason for slowing nominal GDP growth (please see the slowing growth trends in figure 32). This fails to consider three concepts. First, population growth has slowed so GDP will naturally be slower with lower worker hour growth. Second, since inflation is much lower now than in the 1970s and 1980s, one should expect a lower growth rate in investment spending. Last, this expansion has been very long. That means that cumulative investment spending is high, even if spending is growing slowly. Figure 33 shows a more meaningful comparison of historical investment spending. The inflation adjusted five-year average of gross private investment (non-residential) annual spending growth is moving toward a cycle high (the internet bubble was an exaggeration) and the five-year cumulative inflation-adjusted spending as a percent of the five-year average of real GDP is elevated! This is at odds with popular opinion, but of course, I am right. 😊
.
.
Productivity Growth is Slow, But It is Counter Cyclical
.
Productivity growth is essentially real output growth relative to growth in hours worked. Productivity growth has slowed (figures 34, 35, 36, and 38). This is unlikely due to lack of short-term investment as the prior discussion indicated. However, if we take a very long-term view, it does appear that cumulative five-year gross investment (PPI adjusted as productivity is inflation-adjusted) as a percent of the five-year average of real GDP is positively related with five-year growth in productivity (figure 34). Growth in investment is on an uptrend so we could expect productivity growth to improve; the current low growth in productivity could be related to slower investment growth during the financial crisis and first years of the recovery. On an annual basis, investment spending and productivity growth is at best unrelated and at worst slightly negatively related (figures 36 and 37) since the mid-1980s. Since the mid-1980s, the annual change in productivity has had a sometimes-negative relationship with real GDP growth as well (figure 35). Perhaps, during slowdowns workers lose jobs quicker than sales retreats (or growth slows). Also, remember, investment spending and GDP growth are positively related (figure 32), so both real GDP growth and investment spending should be similarly related to productivity.
.
The movement to a service economy (figure 31) has real implications for productivity. A service economy uses fewer machines. This means that more equipment does not necessarily help the service worker as much as the manufacturing employee. Can a server wait on 2% more tables per year every year, a call center worker answer 2% more calls per year every year, etc.? It is much more difficult to improve productivity for a service economy than a manufacturing economy.
.
Perhaps the best indicator of productivity growth is capacity utilization, and the relationship is generally negative since the late 1980s (figure 38). Capacity utilization measures how much capacity is being used from total available capacity to produce demanded finished products (in manufacturing, mining, and electric and gas utilities). As capacity utilization falls in a recession or slow down, productivity normally rises. Perhaps this is because while one cannot “fire” machinery, one can fire employees. Thus, the remaining employees in a recession just work harder (to retain their jobs) and their productivity rises during recessions. As utilization increases as the economy expands (utilization is pro-cyclical), it becomes more difficult to gain ever increasing amounts of production out of existing workers, especially when unemployment is low and workers are more mobile and can leave if they are overworked. Currently, capacity utilization is below average, but it has risen greatly since the financial crisis so it is not surprising that productivity growth is low. Plus, the overall capacity utilization trend is down since the late 1990s, perhaps as manufacturing moved away from the US and as the economy has become more dependent on services (figure 31).
.
So far, I’ve noted three reasons for low productivity growth: low investment perhaps during and closely following the financial crisis, movement to a service economy, and rising capacity utilization. There is a fourth and perhaps even more important reason for low growth. As noted earlier, overall investment is not low, but the make up of investment is changing with more going to R&D instead of to capital expenditures. Cap ex is used to expand plant and machinery, etc. Therefore, it is used to make more stuff. That more stuff is the numerator of the productivity equation. R&D spending has historically been to create a whole new category of stuff (increasing the numerator of productivity), and it can also be used to improve how much of stuff we make (to be more efficient and productive as worker hours to produce stuff declines (the denominator in the productivity equation)).
.
This is history, but now consider the FANG stocks. Does Amazon’s investment in R&D (and cap ex) for online retail sales result in more stuff? The more likely answer is its investment in online retail does not add stuff to the economy – it just takes away sales from other retailers. Consider Netflix. Growth in sales for Netflix pushed Blockbuster out of business, is harming movie theaters, has resulted in cable cord cutting, etc. Thus, Netflix adds “net” nothing to the economy, pun intended. What about Facebook and Google? They make money from advertising. Has total advertising expenditures in the economy risen significantly as a result of their investments? Not really, as they likely just took advertising business away from other companies. Thus, these behemoths that are growing in market share are not really adding overall sales units (the numerator in productivity) to boost the overall economy. Plus, they may not be significantly reducing worker hours (the denominator in productivity); although, Amazon’s big warehouses may be a more efficient (with people hours) delivery system than retail stores. These firms are mostly just redistributing units – not creating more of them – as they gain share from other companies, and in the process, driving down those firms’ productivity!
.
Productivity Growth Could Take Off
.
As noted above, investments may have long lead times before they lead to productivity growth (figure 34). Investments are rising and are perhaps moderate to high, so better productivity growth may be in store for our future. Several other positive developments may boost productivity as well.
.
Some people argue that over-regulation has led to lower investment spending and lower productivity growth. This could be true, and if partly reversed by the Trump/Republican Administration, may help bump up productivity growth. Although, one must be careful here. Too little regulation in the financial sector may have allowed people with great short-term incentives and pressures to take risks that helped create the financial crisis. The crisis was a result of euphoria (during the bubble) and overinvestment and spending fueled by debt, and panic and underinvestment during and after the crisis to bring overall spending back to equilibrium. The further we move away from the days of the crisis, the fainter the memories of it will become. Those now in control of regulations and corporate actions may not have made the past mistakes. The best way to learn one’s lesson is through experience, so these people are more likely to ignore warning signs and could repeat past mistakes that hurt the economy (the output that is the numerator of the productivity equation) if regulations are reversed, become too lenient, or if enforcement of regulations is lax.
.
Other great new inventions may be on the horizon that could boost productivity and economic growth.
.
- Imagine how much more productive people would be with their daily hours if they can work while their cars drive them? Or, what will happen to productivity if the truck drives itself? While the latter means people are out of jobs (the truck driver), it also means the denominator (worker hours) in the productivity equation goes down and productivity rises.
- Advances in biotechnology and other health care could also lead to growth and productivity gains. If we can eliminate expenses in health care (lower expenses may result in more investments elsewhere to boost output) by developing better solutions in a shorter time (fewer hours), then people would live longer and healthier and more productive lives. Just creating easy methods, with technology, to track and encourage people to take their medicine can save much and improve health outcomes. A healthy person probably can produce more than an unhealthy worker. An older healthy worker is likely more productive – has more knowledge and skills – than a younger worker, so being healthy and able to work longer may boost productivity.
- Big data may increase productivity. It helps to focus corporations’ attention and expenses on the most likely customers (thereby boosting output and reducing hours reaching customers), solve problems quicker (to boost output), etc. Although, perhaps big data will only redistribute which firms produce and sell the end products, like the actions of Amazon, if it leads to winner take all if the little guy cannot afford the big data investments. Then there will be less incentive for the winner to continue to innovate.
- Artificial intelligence and quantum computing may also lead to leaps in productivity over the next 10 to 15 years; although, it could displace many workers and we need a plan to help governments successfully implement changes that may be needed for displaced workers in our future.
.
.
Some Productivity Gains Have Gone to Corporations
.
So why is productivity so important? GDP growth is essentially driven by productivity growth plus population growth (there are other considerations, but population growth drives worker hours) plus inflation. In figure 35, one can see that real GDP growth is productivity plus something, and the something is worker hours. To go from real GDP to nominal GDP, one needs to add inflation. Nominal US GDP growth and sales growth for all corporations are very similar (for firms with 100% of sales in the US). Earnings and cash flows, driven by sales, determines stock value. Thus, wealth through stock gains is tied to productivity growth. Plus, productivity growth leads to a higher standard of living; if people can produce more stuff per hour then they can be paid more per hour and are able to buy more stuff. Also, if corporations are stingy and do not pass along the productivity gains to workers, then they become more profitable which drives up earnings, cash flow, and value even further.
.
People have been confused by low wage growth at this point of the cycle. As shown in figure 39, when unemployment declines wage growth typically picks up. At these points, workers have more maneuverability to change jobs and gain higher wages and to demand raises from existing employers who may worry about them leaving and have increasing difficulty finding replacements.
.
However, inflation has been very low, and inflation tends to be tied to wage growth (figure 40). Does wage growth drive inflation, or inflation drive wage growth, or both? Inflation is not rising quickly, so this could be why workers may be more patient demanding higher wages.
.
Globalization has also limited the US worker’s ability to demand higher wages. Companies do not have to source high cost labor in the US, may automate operations, etc. Thus, over the past decades workers have had to compete with more people in a world economy, and in an economy where there are more opportunities to automate their positions. Some manufacturing moved to other countries. Many call centers in the US are now handled in Asia. Although, the difference in cost of manufacturing in China versus the US has declined as wages have risen in China. Harold Sirkin, Michael Zinser, and Douglas Hohner of Boston Consulting Group note that there is only 10%+ savings producing auto parts in China versus the US (source: Exhibit 3, “Made in America, Again: Why Manufacturing Will Return to the U.S.,” August 2011). Perhaps also aiding the US workers’ ability to demand higher wages is the fact that as more jobs move toward services (figure 31) there will come a point where it is more difficult to automate than it was with manufacturing. However, so far firms have been somewhat successful (e.g., when you call a financial service company, you frequently first talk with an automated operator). On the other hand, a movement to service jobs makes it more difficult to improve productivity that is a key to wage increases.
.
The main long-term driver of wage growth is probably productivity. Lower unemployment will not drive firms to raise wages if those workers do not deliver and are more productive. One will hire workers (and pay them more) over machines if those workers are more productive. But, perhaps to make them more productive one also needs to invest in machines. Figure 41 shows that productivity growth and wage growth are closely related using long-term (five-year) data. Low recent wage growth – even in the face of extra workers becoming scarce – is tied to low rates of productivity growth. Figure 42 shows that growth in employment and investment are closely correlated with GDP.
.
.
As noted, workers have been at a disadvantage due to movement to services, globalization, automation, etc. Corporations have the commanding position, and as you can see in figure 43, productivity has grown faster than real wages for most of the last 45 years. This is as capital consumption has risen as a percent of gross value added (figure 44). Gross Value Added (GVA) is essentially total sales of the business sector less intermediate sales between businesses. Recently, wage gains have caught up with productivity, likely due to low levels of unemployment. However, over the long-term, employees have been on the losing end to investors in corporations, which have benefited from productivity growing faster than wages which has boosted corporate margins (figure 45). This may be fueling the rise of xenophobia and socialism in the US and around the world. The trend toward higher margins accelerated since 2000.
.
Paying dividends, versus retaining earnings, has also been growing (figure 46). Lower personal tax rates (figure 47) encourages business owners to take money out of corporations instead of reinvesting to delay taxes (capital gains from reinvested capital that creates growth and value results in delayed taxes). Firms may also be distributing more dividends because margins are higher, and thus cash flow is higher, and less reinvestment is needed if growth is slower due to a declining rate of population growth.
.
Lower corporate tax rates have directly increased the bottom line profit margin (figure 48), plus lower interest rates since the early 1980s have helped margins as well (figure 49). While additional profits from lower taxes may result in more investment expenditures, evidence shows that a disproportionate share of the gain in margin is going to dividends. This has important implications, as the recent tax cut will lead to more debt. If it does not lead to more growth, our debt situation becomes a greater problem (see my prior comments here). Also, if corporations use their tax savings to grow, they could be forced to grow through investing in capital instead of people given the tight labor market. This will further the move to substituting capital for labor (figure 44) which could put workers in a weaker position come the next recession.
.
.
Investing in Technology: Moderation is the Way to Go
.
Booms are fueled by too much excitement, debt, and investment, and then busts follow that are characterized by too much panic selling, deleveraging, and retrenchment. People, companies, and governments often make extreme, and bad, decisions. Would it surprise you that tech companies that engage in moderate investment spending, are moderately profitable, and are moderately valued perform best? Going back to 1993, I analyzed a myriad of factors to screen for good technology stocks; factors include use of capital (R&D, cap ex, dividends, share buybacks, debt paydown, cash build, etc.), profitability (ROE, margin, FCF/Sales, FCF growth, etc.), and valuation (P/E, P/FCF, P/S, P/B, returns) factors, and a combination of factors. I also divided the period into the end of 1993 through 2006 and the beginning of 2007 through 1Q 2018 to see if the markets have changed over time. The results are essentially the same: moderation is the way to go!
.
Figure 50, 51 and 52 show median returns of technology stocks sorted by uses of capital, profitability, and valuation variables, respectively. The sort occurs every three months. A “3” represents the median company.
.
.
Use of Capital
.
Figure 50 shows three-year returns for stocks with various uses of capital. In most cases, the 2s, 3s, and/or 4s have the highest returns, and the 1s and 5s have lower returns. An exception is dividend per share growth, but still those firms with dividends (and more likely moderate investment since some cash flow is use for dividends) have better returns than those without. (not shown) Plus, if we just consider just the period from 2007 through 1Q 2018, the returns for stocks in the various 1-year dividend growth rate quintiles are essentially the same for 12-month horizons.
.
Moderation makes sense. For instance, companies that may be curtailing growth expenditures, such as R&D and cap expenditures, are probably in trouble. Troubled technology firms may have products, or be in industries, that are becoming obsolete. Unlike other sectors such as materials where reversion occurs as the sectors gyrate with the economic cycle, poor technology may never reverse or come back. On the other end of the spectrum, high investment spending may be indicative of optimism, and these stocks may be overhyped and overvalued.
.
One may normally believe that low debt growth (1) is best, but what if paying off debt is due to not having investment opportunities? Conversely, what if high debt growth (5) is to finance large and expensive acquisitions (high goodwill (5) and asset growth (5)). This is not so good, and the 5s in all of these cases do not generate as high of returns as the 3s. While moderate R&D/Sales and R&D growth (2s and 3s) have the highest returns, high R&D/Sales and R&D growth (1s) have lower returns and only slightly better than low R&D/Sales and low R&D growth (5s). Moderate share growth and stock buybacks is also ideal.
.
.
Growth and Profitability
.
Figure 51 shows 12-month returns for stocks sorted by various measures of profitability and growth. In every case, moderate (3s or 2s) profitability and growth produces the highest returns. (not shown) Although, since 2007, the highest ROE and FCF/Sales companies are best, the high margin companies are second best, and the 4s for sales growth is best (the moderate 2s, 3s, and 4s are still better than the 1s and 5s).
.
Low growth and profitability could be a sign of trouble, high growth may mature plus high profitability drives up competition, and those high growth and profitability companies could be over-hyped and overvalued. Hence, it makes sense that moderate profitability and growth is ideal.
.
.
Valuation
.
Figure 52 shows several valuation and price return metrics. With a 12-month forward horizon, the lowest prior 12-month and 36-month return companies are best. Reversion works. Although, since 2007, moderate 12-month and 36-month return stocks are best (low prior returns stocks still produced very good returns and high prior returns stocks were worst). Also, moderate 3-month and 6-month price momentum led to the best future 12-month returns.
.
In order to group the high valuation multiple (P/E, P/B, P/S, and P/FCF) stocks in the same quintile as stocks with negative earnings, book, and FCF, I flipped the multiples to create E/P, B/P, S/P, and FCF/P ratios, with cheaper stocks having higher ratios and the most inexpensive being labelled 1. You can see that cheap tech stocks perform best, followed by moderately valued companies. (not shown) Performance changes a little since 2007, with moderately valued companies performing best and inexpensive stocks (1s) still performing better than expensive companies (5s).
.
Since valuation multiples measure expectations for growth and risk, we can conclude that moderate to low expectations – even in technology – leads to the best returns. Plus, if these companies also have good profitability, the stocks perform even better (figure 53).
.
.
Summary
.
Avoid the hype as an investor. As a corporation, do not overinvest and do not underinvest. Technology has been leading the markets, as it normally does during a bull market. Contrary to perhaps popular opinion, investments in capital and R&D are moderate to high, and this may be quite important to long-term productivity, growth, and wages. Hopefully, domination by large cap tech will not diminish the incentive to invest, but current trends suggest investigation may be warranted. It is important to set your expectations reasonably (moderately) as an investor and corporation. If you do so, you will be way better off in the long-term.
.