When Will the Tech Wreck End?
It’s been a tough start to 2022 for tech stocks. And they’re not alone – small caps are getting hammered too.
Is this a buying opportunity?
For tech stocks, not so much.
For small caps, maybe.
Let me explain.
Rising interest rates are not good news for tech stocks. These are companies that thrive on growth and cheap capital.
Many, but not all, are valued using metrics that would make most traditional investors blush.
Metrics like price-to-sales are commonplace for highfliers.
Much like during the dot-com bubble, these companies are balloons, trading for 20 to 50 times sales… some even higher.
This puts extreme pressure on sales metrics. Once those numbers are in danger, the balloon lets out air and the valuations begin to strain.
The current pinprick is coming from higher interest rates.
Mark my words: Interest rates are going to be higher in the coming months.
That means more pain for the highfliers.
The first stop for relief may come when the 10-year Treasury rate hits 2% – about 35 to 40 basis points from where it is now.
You see, when rates rise, the conventional wisdom is that the cost of capital increases and the growth rate for highfliers decreases.
Models like DCF (discounted cash flow) show that tech shares face greater valuation pressure as rate increases are plugged in and the timeline is extended out five or 10 years.
That 2% number is very important.
It’s a psychological jolt to the system, and a lot of damage will already have been done by the time we get to that point as investors stumble over each other to exit the highfliers.
That may present a great opportunity for investors looking for companies that are not so overpriced but that get tossed out with the crowd anyway.
At 2%, those opportunities will begin to emerge.
Not all tech stocks are created equally. Some tech companies benefit from higher rates, which are traditionally a tool used to slow inflation.
However, the casualties often come on a greater scale, affecting the overall economy as well.
A higher cost of money means less spending and a push toward greater efficiency. That is where tech stocks can shine – not the insanely priced ones, but the ones that allow companies to increase efficiency and reduce costs.
A company that promises automation of processes is much better than one that allows you to show videos of yourself on social media. The ones that provide utility will win out.
Let’s not forget small caps.
They tend to swoon as well when rates rise. With less access to cheap capital, they are forced to fight an uphill battle with the big boys for everything from money to sales. That hits their multiples as well.
But even in this sector, there is value – small cap value. These companies are identified by their profitability and their ability to generate cash.
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