Can Big Tech stocks continue to lead the equities rally?

AS THE tech-heavy Nasdaq 100 continues to outpace the “old economy” sectors of the US and global economy through the first semester and the artificial intelligence-driven narrative gains steam, concerns over the sustainability of this outperformance are understandably widespread.

Fortunately for investors, the tech-led equity performance has been driven not by speculative valuation-led gains in markets. Instead, unlike in the run-up to the 1999 tech bubble, the rally in 2024 and over the past decade has been driven primarily by earnings. This effectively provides a fundamental driver to the gains realised by investors, in contrast to the speculative excesses of a generation ago.

In 2024 alone, earnings growth expectations of more than 20 per cent have actually allowed valuations in the Nasdaq 100 to decline year to date and still deliver 10 per cent returns for investors.

Earnings driver

Similarly, over the past three years, earnings growth of more than 12.5 per cent in terms of compound annual growth rate (CAGR) has offset the valuation declines seen since the Fed started raising interest rates in early 2022.

Over the last decade, the Nasdaq 100 has delivered nearly 13.5 per cent CAGR earnings growth to outpace the non-tech segments of the market.

Looking at the legacy Big Tech leaders – Apple, Alphabet, Amazon, Meta Platforms and Microsoft – the 17.5 per cent returns delivered through May are increasingly dispersed as the market prices different levels of AI competitiveness looking ahead. However, like the Nasdaq and the US equity market as a whole, valuations have actually declined year to date as earnings growth has driven investor returns.

Indeed, these bellwethers have nearly the smallest valuation premium to the wider S&P 500 since the last of them – Meta Platforms (formerly Facebook) – was listed in 2013. In absolute terms, on average, valuations sit just off of decade lows, allowing investors to focus on earnings prospects to drive returns looking ahead.

On this front, we have seen encouraging developments as well beyond the promise of AI-driven earnings growth. Members of the Big Tech club have begun to follow Apple’s lead, beginning to deploy proactive measures to manage capital more efficiently to drive earnings growth that, using Apple’s experience as a guide, should allow them to sustain earnings per share (EPS) momentum despite their size and dominant market shares.

Capital management

Recall, following the launch of the iPod near the turn of the century and then the iPhone nearly a decade later, Apple grew revenues at an average of 36 per cent through 2013. With margins widening as its sales moved away from the competitive PC industry, overall net profit rose nearly 63 per cent CAGR over the same period while earnings per share climbed almost as fast at 53 per cent CAGR.

As Apple’s position in the industry matured and in spite of the launch of the iPad to create the tablet market globally, revenue growth slowed over the past decade to 7.5 per cent per annum, with outsourcing and tax optimisation driving modest margin expansion.

In combination, these allowed net profits to grow at 10 per cent per annum, slightly faster than the 7 per cent EPS growth for the S&P 500 and short of the nearly 12 per cent per annum growth in the Nasdaq 100 over the same period.

However, recognising the growing maturity of its industry, Apple began deploying an aggressive share buyback programme to return capital to shareholders. From 2013 to 2023, share buybacks drove oustanding shares down nearly 40 per cent over the past decade, almost 5 per cent per annum.

These buybacks allowed the EPS of the consumer electronics giant to rise to 15.5 per cent per annum and, perhaps more importantly, permitted Apple to maintain premium EPS growth compared to both the S&P 500 and the Nasdaq 100 as a whole.

In 2024, online advertising leaders, Meta Platforms and Alphabet (Google), began to deploy similar strategies. Each has shrunk their shares outstanding by nearly 10 per cent or 2 per cent per annum over the past five years, while simultaneously introducing their first-ever cash dividends for shareholders. While short of the pace of Apple buybacks over the past decade, the moves represent the first step towards introducing a similar backstop for premium EPS growth looking ahead.

Margin of safety

This foundation of internally driven earnings growth provides technology investors a margin of safety that their predecessors nearly 25 years ago did not have, allowing shareholders to more comfortably look forward in anticipation of the prospect for a capital spending and innovation-led AI earnings cycle that is admittedly still in its infancy.

Undoubtedly, risks to a technology-led investment remain as this cycle unfolds. The US government has begun to impose taxes on the share buybacks that have helped underpin earnings, and US President Joe Biden has indicated a desire to increase these taxes should he be re-elected in November.

In addition, long-dated bond yields likely remain too low which may pose a headwind to the pace of the capital spending cycle set to unfold as yields begin to normalise as we expect moving into 2025.

Moreover, the broadening cyclical recovery in the global economy should widen the participation in the next leg of the equity market rally moving into the second half of the year. Indeed, just as in the Internet era, more traditional companies leading the deployment and leveraging of these technologies stand to benefit as well, as the next technological revolution unfolds in the years ahead.

We believe technology-driven earnings growth should remain an anchor in investors’ portfolios. This is due to premium earnings growth despite historically low valuation premiums relative to the wider market, plus a broadening backstop to Big Tech earnings momentum, and the optionality of AI-driven innovation and growth looking ahead.

The writer is group chief strategist at Union Bancaire Privee, a private bank and wealth management firm