The market might be at a crossroads. On one side, you have improving economic numbers in the United States, led by consumer confidence, retail sales and falling initial jobless claims. This is happening at a time when valuations in general are not stretched by any means: The S&P PE stands at 13, dividend yields at 2.1%. Interest rates are low and likely to stay that way, which makes valuations seem even more tempting.
On the other, you have the permanent European sovereign Sword of Damocles standing over the market’s head, ready to plunge at a moment’s notice. This leads to caution, to not wanting to be invested. But there is something we can be certain about – with one notable exception, big capitalization tech stocks are simply too cheap.
The following is a table of the 10 largest capitalization tech stocks in the U.S. (including Amgen (AMGN), biotechnology can be considered technology): (Click to enlarge)
There are several things in this list that simply stand out. Except for Amazon.com (AMZN), these stocks – which represent some of the best companies the U.S. has to offer – are undervalued. As a group they actually trade at a discount to the S&P, since they have an average 2011 PE of just 11.9 (excluding Amazon), which compares to S&P 500’s 13.
Every large cap tech stock is expected to show growth in 2012. Usually very low multiples are awarded to situations where declining earnings are somehow expected. Not here. Every single stock is still expected to show growth, making the 2012 PE on this group just 10.7, if you exclude Amazon.com.
Microsoft and Intel are the cheapest
Both from a PE 2011 and EV/EBITDA perspective, Microsoft (MSFT) and Intel (INTC) are the cheapest stocks multiple-wise. Obviously, both are under a strong negative thesis, namely the potential impact of tablets in each of their markets.
However, since there are so many cheap large cap stocks, we cannot say that every stock is under a negative story – indeed, Apple (AAPL), which is a prime benefactor of the tablet market, also trades at a very low valuation. So this is market-wide undervaluation at work, meaning that when it resolves itself, it will probably be market-wide as well.
Most, if not all, are outstanding companies
The lowest ROE on this list of companies is EBAY’s (EBAY) 11.6%, and the average is an impressive 23% - this for companies trading at a PE 2011 average, excluding Amazon.com, of just 10.7! And this with the 10 year interest rates on government debt down at 2%.
Amazon.com is the only black sheep valuation-wise
Not only is Amazon.com trading at a huge, unbelievable, premium to all of the other large capitalization tech companies, it’s also having an ugly year, with earnings plunging by more than 50%. It faces clear threats regarding one of its main competitive advantages (not collecting sales tax in most states), and its earnings estimates for 2012 are still bound to be revised lower, as stated in my article “Amazon.com Will Be Showing Losses As Soon As Q1 2012".
Some even yield more than the S&P. Although traditionally tech companies rarely pay decent dividends, the undervaluation here is so severe that some, like Microsoft and Intel, even pay substantially above the S&P500 yield.
There are many threats, both macro (Europe) and stock-specific, like the tablet effect on Microsoft and Intel, or the approaching competition and generics over at Amgen. Or maybe even the increasing commodification of Cisco’s (CSCO) bread and butter business. But, as a whole, a portfolio of these large cap tech stocks – excluding Amazon.com - stands a very high chance of providing positive – and relevant – returns. The undervaluation is simply too great, and the quality of the companies involved too high for that not to happen from these levels.
For someone wanting to be in the market in spite of all the macro headwinds, it would seem that a long portfolio of these nine tech companies together with a short in Amazon.com would be bound to produce strong results.
Additional disclosure: I am short AMZN by selling naked calls. I might also buy Intel if the opportunity presents itself. I might also go long NDX futures as a proxy for the (long) list.