As any savvy shopper knows, there is a world of difference between a sale and a deal. Just because something is discounted from its initial price does not mean that it is worth buying—perhaps the sticker price was far too high originally, the discount is too small or the item is simply poor quality. Such considerations will be on the minds of people hitting the shops on November 25th for “Black Friday”, a mammoth sale which follows America’s Thanksgiving holiday.
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They are always on the minds of investors. “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down,” Warren Buffett, a celebrated investor, once joked. Most share prices have fallen this year—the s&p 500 index of American stocks has shed more than a fifth of its value—but the prices of technology stocks have plunged most precipitously. The tech-heavy nasdaq is down by almost a third, after poor third-quarter earnings precipitated yet another sell-off. Amazon, Netflix and Meta have this year shed a whopping 48%, 58% and 70% of their value. Such discounts mean tech stocks are certainly on sale. But are they a good deal?
The art of evaluating whether a company is a bargain at its current price is one practised by so-called value investors, who earn that title because they seek out stocks unloved by other investors despite solid fundamentals. For much of the past decade, tech stocks have been an unattractive proposition to these parsimonious types. That is in part down to how value investors assess companies and in part down to the characteristics of tech firms.
The original value investor was Benjamin Graham, an academic and author, in whose footsteps Mr Buffett treads. And Graham relied most of all on two measures: the ratio of share price to earnings, which compares the market value of a firm with its profits; and price to book value, which compares a share price to the value of a company’s assets, such as property, equipment and inventories.
For much of the past decade tech stocks have looked mighty expensive on these measures. At the beginning of the year, the share prices of Alphabet, Amazon, Apple, Meta and Netflix were on average 38 times earnings and 12 times book value. The equivalent figures for the Russell 1000, a broad index of stocks, were 24 times earnings and four times book value. Neither group would have qualified as a deal for Graham: he liked firms priced at below 15 times earnings and 1.5 times book value. But tech’s multiples would have been particularly off-putting.
These sky-high valuations partly reflected tech companies’ characteristics. Firms from Alphabet to Zoom tend to have relatively few physical assets that are captured by book value and many intangible ones—such as software and human capital—that are typically not included. They also tended to be fast growers, meaning that measuring their price against present earnings risked understating future profits. For this reason, tech stocks appealed more to “growth” investors, who tend to buy companies with rapidly rising profits, than they did to value types.
This means value investors missed out on years of growth, but also dodged the recent rout. Are tech prices now low enough for them to take a look? Some stocks, including Amazon and Netflix, remain expensive on favoured measures. Other smaller ones, including PayPal and Zoom, may attract interest. So might two giants. Alphabet, with a price-to-earnings ratio of 17, looks cheaper than most value stocks. Meta, which currently trades at just nine times earnings and two times book value, might have piqued even Graham’s interest. Tech investors have long been conscious of having paid a lot for their shares, but hoped these valuations would be justified in the long-run. The fact that many tech stocks now qualify as value stocks will come as a considerable blow.
Perhaps the idea that value investing and tech stocks are inherently incompatible was simplistic. Modern value investing is practised by all sorts, including a number of quantitative investors such as Cliff Asness at aqr Capital Management, who crunch vast data sets to compare firms against wide and varied measures of their worth. Rather than comparing the results with arbitrary criteria across all kinds of firms, they instead tend to compare them within industries. But one thing remains true regardless of the sophistication of the analysis. Tech stocks today are much better value than they were at the start of the year.
Read more from Buttonwood, our columnist on financial markets:
Financiers’ pronouncements on China do not match their actions (Nov 3rd)
The surprising maturity of the crypto-rave crowd (Oct 27th)
Can Britain escape the “moron risk premium”? (Oct 20th)
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