SCHG: Growth Valuations Remain Stretched

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About: Schwab U.S. Large-Cap Growth ETF (SCHG)
by: Dividend Seeker
Summary

SCHG continues to beat the market, but its valuation is quite high.

In the short term, growth's premium compared to value is at a historically wide spread.

Earnings within the IT sector have been declining in 2019, and that sector makes up over one quarter of SCHG's total assets.

Main Thesis

The purpose of this article is to evaluate the Schwab U.S. Large-Cap Growth ETF (SCHG) as an investment option at its current market price. During my last review, I noted I was shifting away from growth investing for a couple of reasons, and those reasons appear more relevant today. One, with the major indices sitting near all-time highs, I believe it is a good time to take some risk off the table. An easy way to do this is to shift from growth-oriented funds to value-oriented names. This strategy could be well-timed at the moment because the price to own value stocks, compared to growth stocks, is at the widest discount in years. Two, growth investing relies heavily on the IT sector. While this is not "bad", this could cause quite a bit of overlap within a portfolio, as the big IT names also make up a large portion of broad market funds. This may expose investors to more sector-risk than they realize they have. A second point on this exposure is that IT earnings have been broadly declining so far in 2019. This has been another reason why the expense of owning growth compared to value keeps rising, as this is pushing up P/E ratios across the sector. Three, with interest rates set to modestly decline by year-end, investors will likely resume a hunt for yield. SCHG offers a paltry dividend, and growth strategies could suffer if investors decide to build-up their income generating investments. Four, governments in the U.S. and Europe are increasingly interested in taxing big tech. That could pressure the outlook for tech firms such as Alphabet (GOOG), Facebook (FB), and Amazon (AMZN).

Background

First, a little background on SCHG. The fund is managed by Charles Schwab, and its objective is "to track as closely as possible, before fees and expenses, the total return of the Dow Jones U.S. Large-Cap Growth Total Stock Market Index." Currently, SCHG trades at $84.66/share and yields 0.90% annually, based on its last four distributions. I covered SCHG in March and noted that I was shifting away from growth and into more defensive names, primarily to take some risk off the table and also to diversify my portfolio. A main driver was the fact that the top stocks within SCHG are also top holdings within my broad market funds, so I wanted to decrease this overlap. While I am content with this decision, SCHG continues to perform well and has returned about 8% since that review.

With this in mind, I wanted to do an updated review on SCHG to see if I should dive back into the fund, or if I should remain invested elsewhere. After careful consideration, I remain cautious on growth stocks relative to other investment themes, and I will explain why in detail below.

The Spread Between Growth And Value Is Very Wide

To start, I want to first demonstrate a key reason why I am shifting assets to more value-oriented sectors and stocks. The primary reason is valuation not just because of face value but because of the relative spread between the two strategies. While growth investing has been a winning theme post-recession, this has come at the expense of value investing, and the relative spread between the two has been widening consistently. While this is not new, the level of the spread is currently at historic levels. In fact, the divergence between value and growth is at its widest level since 2000, as shown below:

Source: Bloomberg

As you can see, the growth theme has been very beneficial over time and it has come at value's expense. Clearly, growth has the momentum, but the graph also illustrates some sharp moves in favor of value. While I cannot predict the future, shifting gears at a time when the gap has widened this dramatically tells me that is a very prudent course of action. Could the spread widen more? Of course. While timing the market is notoriously difficult, this graph illustrates to me that taking risk off the table is a wise move based on historical norms.

Building on this point is the cost to own SCHG, relative to other investments. While seeing price go up does not always mean a P/E ratio will climb, it does if the earnings growth does not match the share price gains. Not surprisingly, SCHG currently has a P/E ratio well above the market average. Not only that, it is about 50% higher than value. To illustrate this point, I have compiled the P/E ratio of SCHG against alternative Schwab funds with dividend, value, and broad market objectives. These funds are Schwab U.S. Large-Cap Value ETF (SCHV), Schwab U.S. Broad Market ETF (SCHB), and Schwab U.S. Dividend Equity ETF (SCHD), shown below:

Fund P/E Ratio
SCHG 23
SCHV 15
SCHB 19
SCHD 16

Source: Charles Schwab

As you can see, it is clear SCHG is relatively expensive to own, especially when compared to value and dividend funds. My point here is that if investors are concerned with their level of risk, rotating into value or dividend strategies may make a lot of sense. It will provide income, take some risk off the table, and protect against some downside risk. While investors are normally expected to pay up for growth strategies, the cost of doing so seems quite high, which supports my cautious outlook.

Tech Earnings On The Decline

As I mentioned, SCHG is heavily weighted towards the IT sector, which makes sense given the high-growth focus of the fund. With IT being a top long-term performer, the fund's exposure to this sector has risen over time. In fact, IT makes up almost 29% of SCHG's total portfolio and is the fund's largest sector by weighting, as shown below:

Source: Charles Schwab

Clearly, this is critical area for SCHG, so understanding how this sector is performing is important. So far this year, IT has been a driving force behind gains for the fund, as the sector has performed markedly better than the S&P 500, as shown below:

Source: Fidelity

This large sector gain helps to explain why SCHG is performing strongly in 2019. However, even though IT share prices have been rising, actual earnings per share for IT stocks are down in 2019, as shown below:

Source: Bloomberg

My takeaway here is cautious. Earnings are high, there is no doubt about that, but the recent weakness is certainly a cause for concern. Furthermore, this helps illustrate why the P/E of SCHG has gotten so high. P/E ratios will increase if share prices rise and/or if earnings decline. Both of these scenarios are occurring right now, which tells me this could be a good time to take some profit. Tech stocks have been soaring higher, but their underlying performance may not be strong enough to truly justify those gains. Selling into this market strength, due to concerns over earnings potential, appears to be a prudent course of action.

New Regulations and Higher Taxes Coming?

A final point on SCHG again has to do with the IT sector. Specifically, concerns are brewing over increased levels of government taxation, and perhaps regulation, of the major IT companies. This should have investors concerned, and it presents headwinds going forward. With major elections coming up, such as the selection of a U.K. Prime Minister and a U.S. presidential election, candidates could be encouraged to get "tough on tech" to stir up populist support. Names that are constantly thrown around as corporate tax abusers are GOOG, FB, and AMZN, which happen to make up 13% of SCHG's total assets.

In fact, "digital taxes" aimed at those companies was a focus of the G-20 summit last month. As reported by CNBC, the G-20 finance ministers agreed to introduce rules on digital taxes for tech companies by 2020. Ideas such as a "global minimum tax" was discussed, which would curtail some of the offshoring of profits to low-tax havens, a tactic popular among big tech companies, especially in Europe. And this concept has support from Boris Johnson, a current favorite to become the new U.K. Prime Minister. Last week, he was quoted:

We've got to find a way of taxing the internet giants on their income, because at the moment it is simply unfair"

My takeaway here is there is an appetite among developed countries to regulate big tech, whether through a more aggressive tax scheme or other means. While it is too early to say for sure what the impact will be, this headwind could clearly impact net profit for some of the largest IT companies. With earnings already feeling some pressure, this is another reason for investors to consider how much of a premium they want to pay for growth.

The Counter-Point

Of course, there is a clear counter-argument to the thesis I just detailed. Growth investing has been a winning strategy and that could continue going forward. For investors who are well-suited to handle above-average risk and volatility, the long-term trend of this investment theme is positive. Furthermore, even as headwinds face the IT sector, its inclusion in SCHG has helped the fund beat other investment themes since 2019 began. In fact, the performance differential is quite noticeable, as shown in the graph below:

Source: CNBC

As you can see, SCHG would have served investors very well this year, and that is a story that could certainly continue. With interest rates remaining low (and possibly going lower), a strengthening employment picture in the U.S., and progress being made on U.S.-China trade issues, the "risk-on" play could remain on. If so, SCHG will likely continue to perform well, and the high price to own the fund may not be a deterrent.

Furthermore, the positive progress on the trade front is especially beneficial for large tech names. This is largely because the IT sector is very trade-sensitive, with over half the sector's revenue coming from non-U.S. sources, as shown below:

Source: Cohen & Steers

As you can see, IT is the most trade-sensitive sector, based on foreign revenue. Therefore, any progress in resolving trade disputes should disproportionately benefit this sector.

And we have seen short-term progress. While I believe trade represents a broad headwind for the market, there was a silver lining that came out of the G-20 summit that wrapped up a few weeks ago. Specifically, as reported by CNBC, both President Trump and President Xi agreed to continue negotiations without applying any new tariffs on each other's respective countries. This was a step in the right direction, as it signals a willingness to come to the table to resolve differences, without letting things escalate at the present moment. Whether these future negotiations will result in amiable terms remains to be seen, but it does help diffuse what is becoming a major market concern. For now, I view this as a positive for the IT sector, and SCHG as well.

Bottom line

SCHG continues to perform well this year, but I remain confident my cautious approach is justified. With IT having a large weighting in my core market funds, Vanguard Total Stock Market ETF (VTI) and SPDR S&P 500 Trust ETF (SPY), I see no need for additional IT exposure with growth funds. Furthermore, growth remains very richly priced, which tells me now is a time to be selective about new positions. SCHG has a P/E well above the market average, and the price to own growth, relative to value, is at decade highs. Finally, IT earnings have been trending lower in 2019, which is never a good sign. While Q2 could mark a swift turnaround, I feel comfortable knowing my broad market funds will benefit from any positive post-earnings reaction and do not need SCHG to profit from that potential upside. Therefore, I continue to invest elsewhere and plan to avoid new positions in SCHG at this time.

Disclosure: I am/we are long SCHD, SCHV, SPY, VTI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.