Many tech stocks outperformed the broader market last year, as the pandemic and stay-at-home trends turned many cloud, e-commerce, fintech, and gaming companies into defensive investments. Those companies were insulated from the pandemic, and some of them even generated accelerating growth throughout the crisis.
However, many of those high-flying stocks have lost their luster over the past month as investors rotated from growth stocks to value stocks. Let’s see why that rotation crushed many tech stocks, and whether or not investors should shop for bargains in this beaten-down sector.
Why are the tech stocks crashing?
Investors are rotating out of high-growth tech stocks for three main reasons.
First, many of these stocks were trading at unsustainable valuations. It’s generally risky to pay over 20 times sales for an unprofitable tech company, but those frothy price-to-sales ratios became the “new normal” throughout the pandemic.
Second, rising vaccination rates make stocks across other battered sectors — such as retail, travel, and energy — cheaper relative to their growth as more businesses reopen. Meanwhile, tech stocks that soared throughout the pandemic will face tough year-over-year comparisons after the crisis ends.
Lastly, the prospects of a post-pandemic economic recovery are causing bond yields to rise. In particular, the rapid rise of the 10-year Treasury yield, which recently surpassed 1.7%, is nudging investors to sell more of their stocks and park more of their cash in government-backed bonds.
Here’s what happened to Zoom Video Communications (NASDAQ:ZM) and Shopify (NYSE:SHOP), which both generated robust growth throughout the pandemic, as the 10-year Treasury’s yield rose this year.
Both companies will face tough comparisons in a post-pandemic world. People could rely less on Zoom’s video conferencing tools as they return to work and school, and fewer businesses might open online stores with Shopify. As a result, both companies will inevitably generate slower growth this year, but their stocks are still trading at high price-to-sales ratios.
Therefore, I wouldn’t recommend buying any of these hyper-growth stocks until their valuations cool off.
Focus on the cheaper tech stocks instead
In this environment, it makes more sense to buy two other kinds of tech stocks.
First, “mature tech” companies like Oracle (NYSE:ORCL) and Cisco Systems (NASDAQ:CSCO), which both trade at 15 times forward earnings, should resist the downturn. Both companies generate slow growth, but their stocks are cheap, they pay higher dividend yields than the 10-year Treasury, and they should grow faster in a post-pandemic world as enterprise customers ramp up their spending again.
Second, market leaders that generate double-digit percentage sales growth, aren’t dependent on stay-at-home trends, and trade at reasonable valuations are still worth buying. It might seem tough to find companies that check all three boxes, but salesforce.com (NYSE:CRM) and Palo Alto Networks (NYSE:PANW) fit the bill.
Salesforce, a cloud services giant that expects to double its annual revenue by fiscal 2026, trades at just 50 times forward earnings and eight times this year’s sales. Analysts expect Palo Alto Networks, one of the world’s top cybersecurity companies, to grow its sales 23% this year — and its stock also looks relatively cheap at 45 times forward earnings and seven times this year’s sales.
For now, investors should still seek out both value and growth stocks across the tech sector, but avoid hyper-growth stocks that generated outsized returns last year and trade at frothy valuations.
However, one cohort to avoid entirely right now is Chinese tech. Many of those companies, including Alibaba, might seem cheap relative to their growth. However, China’s antitrust regulators are squeezing many of those top companies at home as they also face delisting threats in the U.S.
Is it time to buy tech stocks?
Investors should always allocate a portion of their portfolios to tech stocks, since it would be foolish to ignore secular growth trends like 5G networks, artificial intelligence, robotics, semiconductors, and the cloud over the long term.
However, simply chasing the highest growth stocks at any price won’t work this year as the market starts to prioritize sustainable growth and valuations again. In other words, it’s still the right time to buy tech stocks — but investors should be more selective with their choices as we enter a post-pandemic market.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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