Back to top

Image: Bigstock

Tech Leadership Reflects Earnings Power

Read MoreHide Full Article

Technology stocks were market leaders even before Covid-19 arrived, but the pandemic has really cemented these companies’ status. These reasons are obvious; these companies ranging from Alphabet (GOOGL - Free Report) and Facebook (FB - Free Report) to Amazon (AMZN - Free Report) , Apple (AAPL - Free Report) and others have become ever more essential to how we live and work in these socially distanced times.

These companies may not be monopolies, in the legacy legal sense, but they are nevertheless as sustainably profitable as if they were the Standard Oil of the past. The one point I want to make is that these companies’ market leadership and dominance isn’t a result of transitory development or a fad or even a bubble, as some folks allege, but rather a rational reflection of fundamental ground realities.

In other words, the stock market prominence of these Tech companies reflects their enormous and growing earnings power.

As we have pointed out in this space in the past, the composition of the stock market, using the S&P 500 index as a proxy for the market, has undergone a fundamental shift in recent years. This, in turn, is a reflection of the changes in the broader U.S. economy, with a fast-growing and extremely dynamic Technology sector seeping into every nook and cranny of the economy.

The net effect of these compositional changes is that the Technology sector is by far the biggest contributor of earnings to the S&P 500 index, handily eclipsing the Finance sector, which enjoyed the biggest earnings weightage in the index for many years. The chart below plots the earnings contributions of the Zacks Technology and Finance sectors since 2002, with the Energy sector thrown in the mix to further emphasize the aforementioned compositional change:

 

As you can see here, the Technology sector (green line) is on track to bring in 28.9% of the S&P 500 index’s total earnings in 2021, with Finance accounting for 20% and Energy less than 2%.

Not only is the Technology sector bringing in the most money, it also enjoys the best earnings growth profile, as the chart below shows:

 

Please note that while Tech earnings are on track to decline -1.4% this year, the Finance sector and the broader index are expected to see 2020 earnings decline by -23.6% and -17.8%, respectively.

The growth outlook is even more impressive for the big Tech companies, particularly the Big 5 players: Apple, Microsoft (MSFT - Free Report) , Alphabet, Amazon and Facebook.

The table below shows that combined earnings for these 5 big companies are on track to increase by +13.1% on +14% higher revenues this year, followed by +19.3% earnings growth and +17.6% revenue growth in 2021:

 

For a company the size of Apple to be increasing its earnings by +19% in 2021 and +9% in 2022 is impressive anyway you look at it. The growth figures for Amazon are in a different world altogether.

I am not making a valuation comment here, just discussing earnings. Valuation is like beauty — it is in the eye of the beholder.

There can be legitimate concerns that valuation for some of these Tech stocks may have gone a bit too far, particularly following the group’s impressive run-up this year. That said, valuation is as much a function of interest rates as it is of profitability outlook.

We can reasonably assume that the market will be a lot more open to paying a higher multiple for these “growthy" companies in an environment when interest rates are expected to remain low for a long time.  
 
Tech Sector Scorecard

For the Tech sector, we now have Q3 results from 87.1% of the sector’s market capitalization in the S&P 500 index. Total earnings for these Tech companies are up 11.6% from the same period last year on 8.6% higher revenues, with 96.6% beating EPS estimates and 93.1% beating revenue estimates.

The comparison charts below put these results in a historical context, and go some ways towards showing how the sector’s Q3 results are better relative to what we have been seeing in other recent periods, including pre-Covid quarters.

The first set of comparison charts is of the Q3 earnings and revenue growth rates:

 

The second set of comparison charts shows Q3 EPS and revenue beats percentages in the context of recent history:

 

Looking at Q3 as a whole, total Tech sector earnings are expected to be up +10% from the same period last year, on +7.7% higher revenues.

Q3 Earnings Season Scorecard (as of Friday, November 6th)

We now have Q3 results from 447 S&P 500 members or 89.4% of the index’s total membership. Total earnings (or aggregate net income) for these 447 companies are down 7.3% from the same period last year on 1.9% lower revenues, with 85.2% beating EPS estimates and 76.3% beating revenue estimates.

The two sets of comparison charts below put the Q3 results from these 447 index members in a historical context, which should give us a sense how the Q3 earnings season is tracking at this stage relative to other recent periods.

The first set of comparison charts compare the earnings and revenue growth rates for these 447 index members:


 

The second set of charts compare the proportion of these 447 index members beating EPS and revenue estimates:


 

As you can see above, not only is the pace of declines decelerating, but a much bigger proportion of companies are beating EPS and revenue estimates.

The reporting cycle slows down in a notable way going forward, with this week bringing in more than 500 companies to report Q3 results, including 15 S&P 500 members. The notable companies reporting results in the coming week include Disney (DIS - Free Report) , Cisco (CSCO - Free Report) , Applied Materials (AMAT - Free Report) and others.

Looking at Q3 as a whole, combining the actual results that have come out with estimates for the still-to-come companies, total earnings for the index are expected to be down 8.9% on 1.4% lower revenues.

The key factor from the market’s standpoint is how estimates for 2020 Q4 evolve as we go through the remainder of the Q3 reporting cycle. The trend thus far is positive, as the chart below shows:

 

Please note that the revisions trend appears to have leveled off in recent days, with estimates effectively stalling out. The 11.7% decline for Q4 is unchanged over the past week.  

The chart below takes a big-picture view of the quarters, showing Q3 earnings (green bars) and revenue (orange bars) growth in the context of what was actually achieved in the last few quarters and what is expected in the coming periods:

 

The chart below presents the big-picture view on an annual basis. As you can see below, 2020 earnings and revenues are expected to be down 19% and 4.4%, respectively:

 

The above annual growth picture approximates to an index ‘EPS’ of $131.57 for 2020, down from $160.04 in 2019 and $160.63 in 2021.

For an in-depth look at the overall earnings picture and expectations for the coming quarters, please check out our weekly Earnings Trends report >>>> The Favorable Earnings Picture Continues for Q3 & Beyond

Looking for Stocks with Skyrocketing Upside?

Zacks has just released a Special Report on the booming investment opportunities of legal marijuana.

Ignited by new referendums and legislation, this industry is expected to blast from an already robust $6.7 billion to $20.2 billion in 2021. Early investors stand to make a killing, but you have to be ready to act and know just where to look.

See the pot trades we're targeting>>