Our companies analyst assesses the damage that inflation and rising interest rates could do to highly valued US growth stocks.
As reality dawns that the US Federal Reserve is contemplating three interest rate rises next year, large-cap tech stocks have borne the brunt of equity selling this week.
Pay attention to this dynamic. It could yet prove short-term noise, and if current inflation subsides, money could be attracted back to the big name FAANGs in particular. But if these are early rumblings of a tectonic shift in financial markets, they are liable to impact any equity buoyed up above the value of its intrinsic growth.
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Up to now, consensus was that a US rate rise might not have been needed until 2023. But with core inflation testing 5%, the Federal Reserve governor has dropped the ‘transitory’ word.
A former Fed official has argued that the Fed should raise rates at each of its meetings in the first half of next year and keep going until inflation reduces to near 2%. An implied Federal funds rate of over 2.5% against the current 0.25% would shock markets and entail some economic pain but eliminate further pain in future.
I doubt the Fed would swallow that argument; indeed, most central banks nowadays cower from upsetting financial markets. The test will come when inflation fails to ease in response to minuscule rate rises, leaving policymakers baffled in the face of stagflation.
Why growth stocks are exposed to this change
Growth stocks have justifiably enjoyed a premium given the scarcity of growth since the 2008 financial crisis, in the face of very low inflation and interest rates.
Few businesses have been able to grow revenue to an extent that excites the stock market, with above-average margins. Others have typically sought acquisitions to bolster growth, while mature cash-generative businesses have appeased investors with buybacks and dividends.
Momentum trading, together with a colossal amount of extra cash at the heart of the financial system since March 2020, has resulted in US technology valuations in particular soaring to levels that cannot escape mean-reversion.
Watching the likes of Apple (NASDAQ:AAPL) and Microsoft (NASDAQ:MSFT) in the last decade, I have seen their price/earnings (PE) multiples expand from high single-figure historic multiples to over 40x.
But say core inflation was to settle around 5% after rising higher in the short term: even if Microsoft grows annual earnings in line with consensus expectations for 15% over the next five years, its real rate of growth would only just be double-digits. Inflation must subside, otherwise the mean-reversion of its stock rating could be substantial.
Microsoft shares sensitive to current market unease
Indeed, Microsoft was among the biggest US equity fallers both early and later this week – each time by around 3%, with a bit of recovery in between – closing yesterday at $325. Yet barely two months ago, at third-quarter 2021 results, its CEO Satya Nadella (pictured) declared “widespread momentum across the group”.
Nadella said: “We are off to a strong start in the 2022 financial year, with tremendous opportunity to drive sustained long-term revenue growth…businesses small and large are improving productivity and affordability by building tech intensity.”
In response to those results, the consensus price target among Wall Street analysts rose to $375 and I uncomfortably held my nose with a “hold” stance at $323. Given the change under way in the macro environment, I think this now tips towards “sell”.
Big tech stocks especially have run to such hot ratings that their holders may shudder under a cold shower of rate rises. I am not convinced the market is so efficient that this week’s drop in Microsoft and other large-cap tech stocks has priced in what lies ahead.
Apple fails to respond to Bank of America’s upgrade
Early this week Apple’s stock eased nearly 1% despite Bank of America upgrading the same day. After a modest bounce it fell 4% to $172 yesterday.
When market leaders fail to respond positively to upgrades, it can reflect a tired bull market. Or possibly macro change is now seen as more pertinent.
I think the economic change under way similarly implies a material downside risk to Apple, hence on a medium-term view, as for Microsoft, I tilt to “sell”.
Yes, an adage declares you should invest according to a company’s long-term prospects, strength of international branding and so on. But I think we have seen exceptional circumstances, with ultra-low interest rates and the creation of a massive amount of cash. If we are entering a new era of inflation, then richly valued tech stocks will continue to mean-revert.
Shift4 has de-rated amid the effects of Covid
Eighteen months ago, I drew attention to the flotation of Shift4 Payments (NYSE:FOUR), a global leader in secure payment processing. Its stock rose from $35 to test $100 several times last spring, but has since fallen to $52.
This may reflect the fact that markets are partly efficient. Shift4 has been targeted for mean-reversion given it is only on the verge of profitability. A current market cap of $4.3 billion (£3.2 billion) is roughly 3.5x sales compared with 8.3x for Apple or 14.8x for Microsoft.
Sentiment has also been hurt by the stock missing expectations for its third quarter, due to the Covid Delta variant affecting the hotels and restaurants to which Shift4 is exposed. Like-for-like revenue still rose 90% on the 2020 quarter and nearly 130% on 2019, with a $5.6 million operating loss compared with $3.9 million a year before.
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Management proclaims a strong competitive advantage in Shift4’s integrated payments technology with hybrid cloud features, and says it will be able to unlock further revenue opportunities as the platform is rolled out. It consequently raised 2021 revenue guidance, but Omicron may impact that.
More positively, the stock did temporarily soar 20% in early November when a five-year partnership was announced with SpaceX’s Starlink satellite internet service – which management claims could be worth $100 billion in long-term subscription payments.
I cited Shift4 among various US flotations to illustrate how a bull market needs potential new leaders. While a lossmaker is manifestly riskier than a profits juggernaut such as Microsoft, as and when it does break into profit the scope to leverage is greater from a revenue base that is 140th of Microsoft’s. A “hold” stance therefore seems appropriate, despite the ongoing risks of disruption from the pandemic.
How relevant is all this to UK market valuations?
We do not have anything like the scale of America’s global technology behemoths. Microchip developer ARM Holdings was acquired for £23 billion in 2016 by a Japanese conglomerate and sold on; similarly, financial software and systems operator Fidessa Group (originally Royalblue plc) was aquired by Swiss group Ion in 2018, for £1.4 billion.
There is not the same extent of overvaluation or potential for deflation in our market indices.
High ratings do exist in selective small-cap tech stocks, such as Beeks Financial Cloud (LSE:BKS), a niche cloud computing group for financial futures and foreign exchange trading. It enjoys a forward PE of over 40x, based on expectations for net profit to rise to £3 million in its June 2023 year. Having followed Fidessa’s evolution through the 2000 tech stock boom and bust, I am willing to retain a “hold” stance.
Be aware, however, that if the Bank of England is forced into a series of rate rises in defence of its 2% inflation mandate, any growth stock rated materially above its fundamentals will be exposed.
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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