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- Goldman Sachs says investors in the technology and software sectors are ignoring important market risks and leaving themselves unprepared for a changing political landscape.
- The firm also explains why lofty valuations are reflecting a growth overreach in the late cycle economy.
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Valuations in the technology sector have gone completely haywire.
Although it’s fairly common for investors to overreach this late in an economic cycle, appetite for software and technology firms has looked beyond insatiable at times. Investors are pulling out all the stops in order to capture a sliver of these firms’ strong profits — and taking on an increasing amount of risk in a last-ditch effort to outperform.
In general, when sentiment and excitement surrounding a sector’s growth potential shifts to extremes, investors tend to turn a blind eye to other prevailing risks.
Now, prescient market analysts are sounding the alarm on once-ignored risks.
Goldman Sachs has a stark message for technology investors: stop ignoring regulation and concentration risks.
"Due to the heated political landscape and the rise in US equity market concentration, we expect regulation will remain a persistent headline risk," a group of strategists from Goldman Sachs relayed.
With only five stocks accounting for roughly 13% of the S&P 500‘s $22 trillion market capitalization — each of which falls under the tech umbrella — it’s easy to see why Goldman is pleading with investors to heed their warning.
The technology sector is now trading at a valuation premium two standard deviations above its 10-year average, while the median software stock trades at nearly its highest enterprise-value-to-sales ratio since the tech bubble, making it easy to see that the market’s affinity for high-flying-growth stocks is way overdone.
The graph below shows just how aggressively investors have bid up the prices of software firms:
When this happens, smaller-cap issues are squashed under the immense pressure of a few mega-cap stocks, exacerbating concealed risk within indices. And when companies grow to this gargantuan size, rest assured they’ll end up in the middle of politicians’ crosshairs.
"Uncertainty surrounding potential litigation is high, but historical precedent suggests that investors should reduce exposures to targeted companies in the event of an antitrust lawsuit," Goldman said.
Put briefly, they think it’s time to get out — or at least hedge accordingly.
Several 2020 political candidates have already expressed distaste for large tech firms, citing outsized profits, huge C-suite salaries, low tax rates, and ethical mishaps. Historically, when these firms are targeted, Goldman finds that valuations and share prices decline, sales growth slows, and valuable resources become tied up in litigation for years.
The subsequent impact of political conflicts will vary depending on the candidate, but ditching the names that account for the most exposure is a good place to start. Goldman suggests instead searching for names with strong revenue growth, high profit margins, low multiples, and low risk of antitrust regulation — and to do it now.
Overall, no one knows how long the party in the technology sector will last. And no one likes a guest who overstays their welcome.
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