Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 385

Is your portfolio too heavy on technology stocks?

Even if you don’t hold any technology stocks or tech-sector funds, your portfolio might be more tech-heavy than you think. If you invest in a US index fund, the tech sector now accounts for 24.2% of the S&P 500.

Communication services, which is home to tech-oriented leaders such as Alphabet (NAS:GOOGL), Facebook (NAS:FB), and Twitter (NYS:TWTR), made up another 11% of the benchmark as of 31 October 2020.

Tech leaders have dominated returns for the index for seven years running; as a result, the largest companies in the index are all big tech names, including Apple (NAS:AAPL), Microsoft (NAS:MSFT), Amazon.com (NAS:AMZN), and Facebook. (Amazon is officially part of the consumer cyclical sector, but obviously tech related.) Those five companies alone now account for about 23% of the index’s value.

Because the S&P 500 is such a widely-used benchmark, thousands of index funds, Exchange Traded Funds, and actively-managed funds also have large amounts of exposure to the tech sector. While there are good reasons behind tech’s growing dominance, it also warrants a bit of caution. In this article, I’ll delve into what’s been driving the surge in tech stocks, why this is potentially problematic for investors, and how to adjust your portfolio to mitigate the risk.

The rising tide

Over the past 31 years, the tech sector’s weighting has nearly tripled as a percentage of the S&P 500. Over that period, the weighting has been as low as 6.3% (at the end of 1992) and as high as 33.0% (in August 2000). The high-water mark in 2000, of course, marked the beginning of the end of the tech bubble, when hundreds of Internet startups with inflated valuations quickly dropped down to earth. More established tech names held up better but also experienced significant drops. Between 2000 and the end of 2003, Morningstar’s US Technology Index lost more than 70% of its value in cumulative terms.

Since then, the sector has steadily climbed, suffering only a temporary drop during the fourth quarter of 2018’s market jitters. Tech stocks even held up better than average when the novel coronavirus roiled the market in March 2020. More recently, some market pundits have even gone so far as to describe technology as a safe haven.

No worries?

The size of any sector’s weighting in itself doesn’t necessarily mean a correction is imminent. Market valuations represent the collective wisdom of market participants about the underlying value of each company. 

Many of the more recent shifts in sector weightings reflect changes in the nature of the economy. We can look at sector weightings going back to September 1989 (the earliest date for Morningstar’s sector data) to see how the overall makeup of 'the market' has shifted over time. Over the past 31 years, old-economy sectors, such as basic materials, energy, consumer goods, and industrials, have all declined, while technology, healthcare, communication services, and financial services have increased in percentage terms.

To a large extent, these changes reflect the underlying economic contributions of each company. If we aggregate all of the financial statements for the companies included in the S&P 500, for example, the tech sector accounts for a large percentage of the total revenue, operating income, and free cash flow generated over the past 12 months. Those are all key inputs that help drive the underlying value of a company.

What’s more, equity values are forward-looking, so the large tech weighting also reflects the expectation that companies in the sector will continue generating above-average growth. Indeed, the median five-year earnings growth estimates from Wall Street analysts are higher for companies in the tech sector than nearly any other sector.

The positive trends driving technological growth show no signs of stopping. Some of these include the acceleration of digital tools in all aspects of life, 5G mobile network standards, and productivity-enhancing technologies like artificial intelligence and robotic automation.

Potential danger signs

But even if tech lives up to its high growth expectations, are the assumptions baked into current stock prices too high?

Morningstar’s equity analysts calculate fair value estimates for individual stocks under analyst coverage, with the values based on detailed models of projected future cash flows (discounted to present value). On that basis, tech-stock valuations look a bit steep. As of 12 November 2020, the median tech stock in our coverage universe was trading at a price/fair value ratio of 1.12. That’s down a bit from a recent peak in October 2020, but still relatively rich.

Other valuation metrics also look relatively lofty compared with historical levels, as shown in the chart below. Average ratios for price/earnings, price/book, price/cash flow, and price/sales have all been on an upward trend over the past several years. Three of these four metrics now stand higher than they did at the end of 2000. Morningstar’s historical data for price/free cash flow doesn’t start until 2009, but that metric is also well above past levels.

Portfolio tweaks for tech-wary investors

None of this data is a flashing red light suggesting that investors should bail out on tech stocks. But I think there’s enough evidence to warrant some caution.

A logical first step is to figure out exactly how exposed you are to the sector. In addition to hefty weightings in most market indexes, any individual stock holdings you own may have ballooned to surprising levels. Making matters worse, many of these holdings have large unrealised gains, making the prospect of selling pretty unappetising.

One way to dial back tech exposure is to consider adding positions in other areas as a counterweight. Adding assets to a value-oriented fund is one way to counterbalance the tech-oriented growth stocks that have dominated the market in recent years. Finally, consider adding a small stake in sectors that have historically had lower correlations with the tech sector, such as energy, utilities, and real estate.

 

Amy C. Arnott, CFA, is Director of Securities Analysis for Morningstar. This article is general information and does not consider the circumstances of any investor. It has been modified somewhat from the original US version for an Australian audience. 

Register for a free trial of Morningstar Premium on the link below, including the portfolio management service, Sharesight.


Try Morningstar Premium for free


 

RELATED ARTICLES

Why the tech giants still impress

Why the four tech giants are not expensive

The connectivity revolution is only just beginning

banner

Most viewed in recent weeks

24 hot stocks and funds for 2021

Many investors use the new year to review their portfolios, and in this free ebook, two dozen fund managers and product providers give their best ideas for 2021 - some stocks, some funds, some sectors.

Great new ways the Government helps retirees

Last year's retiree checklist of services available was one of our most popular articles. There are some additions for 2021, and while it can take effort to set them up, they can pay off over the long term.

The hazards of asset allocation in a late-stage major bubble

The Grantham article everyone is quoting, in full. "The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble ... this could very well be the most important event of your investing lives."

Four simple strategies deliver long-term investing comfort

A long-time advocate of the merits of generating income by investing in industrial companies rather than bonds or deposits checks his 'mothership' chart for the latest results, and continues to feel vindicated.

Cut it out ... millionaires are not wealthy

The widespread use of 'millionaire' must stop. Inflation means that the basket of goods and services that cost $1 million in 1960 now requires $15 million. Today, millionaires are not wealthy.

Retirement changes everything: a post-retirement investing framework

Categorising post-retirement needs – living, lifestyle, legacy and contingency – creates a framework for retirees. Advisers can translate these needs into investment goals and portfolios.

Latest Updates

Investment strategies

Unfortunately, all fund manager presentations are good

Part of the fund manager's job is to raise money from investors, and with years of practice, a few good stock stories and an educated guess on the future, it's not hard to present well. That's a problem for investors.

Latest from Morningstar

Win some, lose some: Buffett's 2020 scorecard

Warren Buffett's investment portfolio gains attention because of his legendary status, but parts of his empire in insurance, railways, metalworking and aircraft suppliers have been damaged by the pandemic.

Shares

Prefer or defer? Sector and investment themes for 2021

It's time for equity prices to more closely tie to a company’s underlying near-term earnings trajectory and financial strength. Despite the market trading at record levels, some stocks have been left behind.

Retirement

Is cancelling the SG increase a retiree version of ‘Buy now, pay later’?

No doubt, any reduction or deferral in the SG increase would be received favourably by many. However, early access and lower contributions undermine the foundation of our super system.

Three ways to match housing affordability with good returns

This increased focus on affordable housing is welcome but the challenge is that investors typically require ‘market’ rate financial returns. By definition, social housing tenants cannot pay market rent.

Investment strategies

Investors face their own Breaking Bad moment

Savers are making small decision after small decision that leads them away from investing and closer to outright speculating. Time will tell if this ends in a bloody climax or we all live happily ever after.

Shares

Australian banks prove resilient but risks remain

Australian major banks reported a decline in financial performance in 2020 but as the impact of the pandemic evolves, the banks maintained a strong focus on customers. Is the renewed market optimism justified?

  • KPMG
  • 1 January 2020

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.