Is Your Portfolio too Tech-Heavy?

If yes, investors may want consider adding a counterweight to their tech-heavy portfolios writes Amy Arnott

Amy C. Arnott 25 November, 2020 | 12:44AM
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Even if you don’t hold any technology stocks or specific tech-sector funds, your portfolio might be more tech-heavy than you think. The sector now accounts for 24.2% of the S&P 500. 

The communication services sector, meanwhile, is home to tech-oriented leaders such as Alphabet (GOOGL), Facebook (FB), and Twitter (TWTR), made up another 11%. That means any investor with a Global or US fund is likely to have a decent chunk of their money in tech stocks. 

Tech leaders have dominated returns for the S&P 500 for seven years running; as a result, the largest companies in the index are all big tech names, including Apple (AAPL), Microsoft (MSFT), Facebook, and Amazon (AMZN) - 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 tracker funds, exchange-traded funds (ETFs), 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. Here, we 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.% (in August 2000). The peak 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 fell by more than 70%.

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Since then, the sector has steadily climbed, suffering only a temporary drop during market jitters in the fourth quarter of 2018. 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. As the nature of the economy evolves, so do the relative weightings of each sector. If we look back in time to the 1800s, for example, agriculture made up more than a third of all US economic output, gradually dropping to about 20% by 1900.

Many of the more recent shifts in sector weightings also 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.

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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.

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 November 12, 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.

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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.

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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 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 indices, any individual stock holdings you own may have ballooned to surprising levels. 

One way to dial back tech exposure is to add positions in other areas as a counterweight. Many broad-based equity funds have significantly lower weightings in tech stocks and also offer broader diversification benefits. Adding assets to a value-oriented fund is another 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.

Conclusion

The increasing weight of tech stocks in most market benchmarks largely reflects the sector’s strong fundamentals and ability to create economic value. There’s no reason to believe those factors will reverse course. And it doesn’t look like we’re repeating the excesses that led up to the tech bubble in 1999 and 2000: irrational exuberance about the current value of future profits and overly generous funding for startups and IPOs. Even so, investors might want to consider adding a bit of counterweight to tech-heavy portfolios.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Amy C. Arnott  Amy C. Arnott, CFA, is director of securities analysis for Morningstar.