Tech Sector Heavy Hitters: The Only Market Constant is Change

By John Reese (@guruinvestor) — 

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There are precious few certainties when it comes to the stock market, but there’s one that should be written in permanent ink and glued to every screen: Nothing stays the same forever.

Market capitalization, the value of a company’s outstanding shares, provides a snapshot of what the market is valuing most (in absolute terms) at any given time. The loud-and-clear message delivered by today’s market is that the tech sector continues to reign as flavor of the month. And, while this isn’t new and probably won’t end any time soon, it’s important for investors to guard against complacency.

Today’s top five U.S. companies by market cap (as of market close on 10-27) compared to those of 2001 are as follows:

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The fact that the lineup has changed is more logical than it is remarkable. Business cycles, secular trends, competition and profit dynamics change in ways that are extremely difficult to predict. Companies that might have once been considered blue chip and bulletproof can find themselves falling in the food chain—that’s the nature of the market beast. What is more noteworthy today, however, is that the top five U.S. companies by market cap are in the same sector and are responsible in large part for the market’s continued rise.

Since the S&P 500 Index is market capitalization weighted—meaning that its individual components are weighted according to the total value of their shares. Therefore, large price movements in the largest components can have a dramatic effect on the value of the index. Because of this weighting system, tech stocks have been responsible for much of the growth in the S&P 500 of late and, on a more macro level, have played a large role in this bull market’s gains.

Which begs the question: Is it good to place all your eggs in one basket even if the eggs are golden? Here are a few things to consider:

Market breadth: This is a gauge used to broadly measure the nature of a market rally by analyzing the number of stocks that are advancing relative to those that are declining—and the current “narrowness” of the market rally is raising concern for some. A MarketWatch article from earlier this year argues that the narrowness exists “in the form of mega-capitalization growth issues…and mostly technology shares, exerting an undue influence on most major averages.” A CNBC article from last month addresses the issue as well, quoting JP Morgan global strategist David Lebovitz: “As tech becomes a larger and larger component of the S&P 500, its contribution to risk is larger as well.” The risk may not be imminent, as the big tech companies continue to report strong revenue and earnings, but a market lifted primarily by one component is not necessarily a healthy one. And, if performance-chasing investors continue to serve as buoys, risk can elevate as well.

Market capitalization vs. market value: In the timeless words of market guru Warren Buffett, who inspired one of the stock screening models I created for Validea, “Price is what you pay. Value is what you get.” Stocks that you pay up for, he says, are not necessarily going to bring you more income. Again, I’m not casting aspersions on the future return-generating ability of the big tech names, but it’s important for investors to keep in mind that market capitalization does not necessarily reflect the true value of a company.  Widespread enthusiasm regarding a stock or sector will push up share prices, but it’s the underlying fundamentals of the company’s business that is more reflective of its true value. For value investing gurus like Warren Buffett, this is how best to gauge the appeal of a company from an investment perspective.

Technology sector idiosyncrasies: The fact that the tech sector has contributed in a big way to the market’s gains is clear, and there’s good reason to expect this to continue. But there are complex issues associated with the industry that could cause shifts over the long term and shouldn’t be ignored. In the long run, maybe they won’t matter. But knowledge and awareness are valuable weapons to access as a defense against the herd mentality and misguided investment decisions.

In a provocative podcast interview with Bloomberg columnist Barry Ritholtz, Scott Galloway, professor of marketing at NYU’s Stern School of Business (and author of the recent New York Times bestseller, The Four: The Hidden DNA of Amazon, Apple, Facebook, and Google) shares fascinating insights regarding the technology sector and its leaders. While his comments reflect a positive and optimistic view of the sector’s strength and promise, Galloway underscores a series of far-reaching issues associated with the industry’s powerhouse companies. Included among them is Facebook’s push-back from being characterized as a media company and Apple’s positioning as a luxury brand instead of a technology company. Galloway doesn’t suggest that any would necessarily impact earnings or dampen investor enthusiasm, but highlights issues unique to the industry that are fluid and potentially challenging. As an investor, such factors can be difficult, if not impossible, to quantify. This only underscores the need for fundamental analysis of these companies and a diligent approach, as opposed to a knee-jerk, herd-based one—particularly given their heavy weight in the broader market and the high percentage of gains they represent.

Photo: Copyright: feelart / 123RF Stock Photo

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John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Follow John on Twitter @guruinvestor