By Brandon Rakszawski, Senior ETF Product Manager for VanEck Global
Despite the coronavirus concerns that have hit commodity markets and, in turn, energy and basic materials stocks, U.S. tech stocks have posted strong returns to start the year. This continues their impressive streak from 2019. But are the current tech valuations sustainable?
In a recent market note, Brian Colello, Director of Technology, Media and Telecom Equity Research at Morningstar, noted that the median tech stock was 11% overvalued as of January 30. This was one of the highest price/fair value ratios since 2007, according to Colello. Certain sub-industries within tech are more overvalued than others, but a strong fourth quarter and January have erased some discounts to fair value, particularly in semiconductor stocks, which Morningstar viewed as undervalued through much of 2019.
Software companies Microsoft (MSFT) and ServiceNow (NOW), both VanEck Vectors Morningstar Wide Moat ETF (MOAT) holdings, have had their fair value estimate raised in recent weeks following strong quarterly results. Other companies that appeared attractive in 2019 have rallied, leaving the tech sector one to keep an eye on as the impact of the coronavirus on markets becomes known. Colello noted that some tech companies have provided wider bands of revenue guidance, but there is no clear-cut impact to upcoming earnings at this point.
MOAT’s underlying index, Morningstar Wide Moat Focus Index (“Moat Index”), remains underweight tech stocks due to its focus on valuations. Its underexposure benefited the strategy during the trade war-induced selloff in the fourth quarter of 2018. The Moat Index currently maintains overweights to the application software and semiconductor sub-industries within tech. Morningstar will reassess company valuations in March.
Tech Stocks Have Taken Off Since June
Source: Morningstar. Data 1/31/2018 – 1/31/2020. Past performance is no guarantee of future results. For illustrative purposes only.
Healthcare Stocks in Focus: No Major Overhaul Expected
The top sector overweight in the Moat Index remains healthcare, despite a slight decrease in weighting over the last few quarters. Despite solid sector fundamentals, U.S. healthcare stocks underperformed the U.S. market through 2019, driven largely by political rhetoric feeding fears around potential healthcare policy changes.
Damien Conover, Director of Healthcare Equity Research at Morningstar, noted in January that their healthcare coverage universe was slightly overvalued, with the median price/fair value estimate at a 5% premium to fair value. He added that these elevated valuations are being driven by certain sub-industries, such as devices and diagnostics, where some investors are turning in order to maintain some healthcare exposure while avoiding areas more impacted by policy uncertainty, such as pharmaceuticals. One fallout from the potential structural and policy changes in healthcare was the 2019 downgrade of many companies involved in pharmaceutical distribution.
Conover noted that pockets of undervalued stocks within the sector exist. Drug and biotech industries present the most potential in this regard, due to market fears over potential policy limits on drug pricing power. Morningstar views these fears as overblown. According to Morningstar, growth in net drug prices (the price paid after discounts) has decelerated to below inflation, leaving Morningstar to view drug pricing as less of a problem. Therefore, even though some form of U.S. policy reform is probable, Morningstar does not believe a major overhaul is likely.
MOAT offers exposure to the pharmaceutical and biotech industries by holding wide moat stocks Bristol-Myers Squibb (BMY), Pfizer (PFE), Merk & Co (MRK), Biogen (BIIB), Gilead Sciences (GILD) and Amgen (AMGN).
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Fair value estimate: the Morningstar analyst’s estimate of what a stock is worth.
Price/Fair Value: ratio of a stock’s trading price to its fair value estimate.
The Morningstar® Wide Moat Focus IndexSM was created and is maintained by Morningstar, Inc. Morningstar, Inc. does not sponsor, endorse, issue, sell, or promote the VanEck Vectors Morningstar Wide Moat ETF and bears no liability with respect to that ETF or any security. Morningstar® is a registered trademark of Morningstar, Inc. Morningstar® Wide Moat Focus IndexSM is a service mark of Morningstar, Inc
The Morningstar® Wide Moat Focus IndexSM consists of U.S. companies identified as having sustainable, competitive advantages and whose stocks are attractively priced, according to Morningstar.
Morningstar US Market Index represents the top 97% of market capitalization of the U.S. equity markets.
Morningstar US Technology Index represents U.S. equities classified in the technology sector.
Effective June 20, 2016, Morningstar implemented several changes to the Morningstar Wide Moat Focus Index construction rules. Among other changes, the index increased its constituent count from 20 stocks to at least 40 stocks and modified its rebalance and reconstitution methodology. These changes may result in more diversified exposure, lower turnover and longer holding periods for index constituents than under the rules in effect prior to this date.
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