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Market View

For all the recent volatility in the information technology sector, its underlying fundamentals and many longer-term trends bode well for continued growth.

Technology has been very much in the financial press over the past week, thanks to sudden volatility and some awkward abbreviations, like FAAMG—Facebook, Apple, Amazon, Microsoft, Google—which is used to denote five large stocks that have been critical components of the sector’s positive performance year to date. Given the heightened interest among investors and the flow of assets into a trade that some consider to be crowded, we consider three questions about this high-growth segment of the market.

1. What happened this month?

Throughout the first five-plus months of 2017, the information technology (IT) sector led U.S. equity markets higher, driven by investor demand for fast-growing, secular growth stocks, as expectations for fiscal stimulus and policy reform have been reduced since the start of the year. However, as noted in a widely circulated Goldman Sachs report1 on June 9, what was particularly unique about this year’s rally in tech was that it was accompanied by exceedingly low levels of volatility. In fact, the mega-cap tech companies that were primarily responsible for the sector’s strong performance delivered this upside with realized volatility that was not only lower than that of the average stock in the S&P 500® Index but also lower than traditionally defensive sectors such as consumer staples and utilities. As fate would have it, June 9 was also the day that this low-volatility anomaly in tech stocks abruptly ended, with the Nasdaq Composite Index (which had hit an all-time high earlier that day) falling 2%.

While this spike in volatility may have caught some investors off guard, long-term investors will note that volatility is not at all uncommon for the stocks of the fastest-growing companies in the market. When looking at the stocks with the highest revenue growth, a segment of the market that includes many of the tech stocks that have outperformed year to date, it is clear that they tend to deliver long-term outperformance (see Table 1), albeit with higher market valuations and greater volatility on average (see Chart 1).

 

Table 1. High-Growth Companies Have Been Worth Their Premium
Three-year rolling averages (12/31/2006-12/31/2016)

Source: FactSet and Lord Abbett.  Based on annual reported earnings.  Data most recently available.
The average top 10% of high-revenue growth stocks were chosen by screening al companies with a market capitalization greater than $10 billion at the end of each three-year time period and then stacking the companies according to their revenue growth over that three-year time period. 
The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged and are not available for direct investment.

 

Chart 1. High-Growth Stocks Have Been Inherently More Volatile
Three-year standard deviation of returns (12/31/2013-12/31/2016)

Source: FactSet and Lord Abbett.  Based on annual reported earnings.  Data most recently available.
The average top 10% of high-revenue growth stocks were chosen by screening al companies with a market capitalization greater than $10 billion at the end of each three-year time period and then stacking the companies according to their revenue growth over that three-year time period.
The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged and are not available for direct investment. 

 

In short, while higher volatility and premium multiples are two risks to consider with high-revenue growth stocks, the payoff for identifying the future leaders, disrupters, and innovators historically has been well worth it for active managers who are able to identify such opportunities, while managing risk.

2. Is there a bubble in technology stocks?

One initial reaction to the resurgence of tech volatility was for investors to question whether this choppiness signaled a market top for the sector. From a fundamental perspective, we think that there are a number of reasons to believe that this is not the case. As illustrated in the Table 2, compared with the peak of the tech bubble in 2000, the IT sector possesses noticeably stronger sales and earnings, and valuations that are far less extreme than they were in 2000.

 

Table 2. The IT Sector Looks Healthier Today Compared with 2000
The sector now has stronger sales and earnings, and valuations pale in comparison

Source: FactSet.
The historical data shown are for illustrative purposes only and do not represent any specific portfolio by Lord Abbett or any particular investment. Performance quoted represents past performance. Past performance is not a reliable indicator or a guarantee of future results. Indexes are unmanaged and are not available for direct investment.

 

And alongside the underlying fundamental strength of the sector are many long-term reasons to remain optimistic about tech stocks. As we have highlighted previously, developments in cloud computing continue to drive a new wave of tech growth, which may very well still be in its early stages, while ongoing improvements in the processing power of semiconductors and an increasingly interconnected world through social media continue to provide opportunities for sustained growth in this sector. This backdrop has led tech to outperform year to date, and even amid a pick-up in volatility, the fundamental picture remains firmly in place.

In sum, the current environment looks considerably different than the froth of 2000, as many secular growth technology companies and industries are delivering strong organic growth and are not, in our view, demonstrating the excessive valuations and speculative size of the dot-com bubble.

3. What is the best way to invest in innovation?

With volatility in the IT sector potentially returning to historically normal levels (options markets imply a continued uptick in volatility over the next several months), it is an important reminder that an active approach is critical in this market segment for mitigating the risks as well as the common shifts in market sentiment that occur within these stocks.

For investors who are looking to potentially capitalize on the innovation that is inherent in rapidly evolving technologies that are revolutionizing modern society, an approach that seeks to identify the fastest-growing stocks regardless of their market capitalizations may be preferable to a market cap-weighted approach that, by default, has a mega-cap orientation. Uncovering tomorrow’s leaders is a crucial component of a successful high-growth strategy, given the rapid rate of technological advancement and innovation that occurs in this sector.

At the same time, we have noted that the highest-growth stocks tend to come with higher levels of risk, which is why an active approach that is well-diversified among sectors and industries may help better insulate investors from downside during periods of market distress compared with an approach that is highly concentrated in just one sector or in only a few individual holdings.

The potential for downside protection is yet another reason why high-growth investors may desire an active and flexible approach that allows a professional manager to navigate the natural market turbulence in this segment. It is also a significant contrast to a rigid, passive approach that by its mandate will subject investors to the entirety of market downside even during periods of normal volatility.

As such, we believe owning the stocks of innovative companies, in a market where many disruptive technologies are replacing or revolutionizing old businesses, can be part of a portfolio designed to meet long-term investment goals. The key is to avoid rigid, rules-based structures that may lag in market environments where technology falls out of favor or, conversely, when smaller-capitalization stocks lead.

Conclusion
It has been an interesting few weeks for the IT sector, with an uptick in volatility potentially giving some investors pause. However, the sector’s underlying fundamentals and many longer-term trends may bode well for continued growth, and long-term investors know that volatility among the fastest-growing segment of this sector is not abnormal but rather should be expected. This is why we believe an active approach remains critical in today’s market to help manage the risk and capture the potential long-term upside of these high-growth stocks.

 

1 “Is ‘FANG’ Mispriced?” Goldman Sachs Investment Research, June 9, 2017.

 

IMPORTANT INFORMATION
Keep in mind that all investments carry a certain amount of risk including possible loss of the principal amount invested. No investment strategy, including diversification and asset allocation, guarantees a profit or protects against a loss. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, industry, political, regulatory, geopolitical, and other conditions.

There is no assurance that past trends will continue into the future.

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results. Market forecasts and projections are based on current market conditions and are subject to change without notice. Due to market volatility, the market may not perform in a similar manner in the future.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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