Stocks at 40 times profits are cheap, Wall Street has determined

Buying shares trading at 40 times earnings may not sound like a good deal. But that’s exactly what Maneesh Deshpande is telling clients to do.

The head of equity derivatives strategy at Barclays just upgraded his recommendation on Apple Inc. and other technology giants, advising investors to own more of these stocks. Often known as Faamg, the group is getting a reprieve after lagging behind the market since October.

As stretched as the Faamgs look — a 35% premium over the S&P 500 Index — Deshpande says judging valuations based on an absolute level or comparing them to the rest of the market is flawed because it doesn’t acknowledge the growth advantage that these tech giants offer in the long run. In other words, they deserve a higher multiple because of their superior earnings power.

A more appropriate approach, Deshpande says, is to measure the shares against their own history. Going by that, the valuation of Faamg stocks is now on par with levels seen before the pandemic. By contrast, the S&P 500 fetches a premium relative to where it was in December 2019.

“It’s like saying New York real estate is cheap right now, but it’s not going to be as cheap as Montana ever. It’s cheaper relative to where it was,” Deshpande said by phone. “That is still notable.”

The tech behemoths, once superstars at the top of the leaderboard, had a tough start to the year. Their total market value rose less than 8% in the first five months, while indexes tracking commodity and financial shares each advanced more than 20%. The underperformance came during increased Washington discussions about regulations and taxes and as the threat of higher interest rates weighed on richly valued stocks.

Now with inflation expectations starting to abate, the Faamg stocks — Facebook Inc., Apple, Amazon.com Inc., Microsoft Corp. and Google parent Alphabet Inc. — are reclaiming dominance. The group has climbed 6.3% this month, a gain that none of the 11 main S&P 500 industries has been able to beat. Without them, the index’s 0.9% gain would have reversed to a loss of 0.4%.

In other words, Deshpande’s line of thinking seems to be resonating in the market. At least for now.

“You really have a group that’s underperformed the broader tape, that is still growing earnings and that’s how they get cheaper,” said Art Hogan, chief strategist at National Securities. “A 30% grower should probably be ascribed something higher than a steel mill growing at 8%.”

Indeed, the Faamg’s combined income expanded by an annual average 15% in the past five years, four times the S&P 500 as a whole. While their growth is expected to begin lagging this quarter, their edge will likely return in the second half of next year, analyst estimates compiled by Bloomberg Intelligence show.

Not everyone agrees that Faamg stocks look like bargains. David Donabedian, chief investment officer of CIBC Private Wealth Management, says that economically sensitive stocks are more attractive right now. Banks, for instance, are valued at a P/E multiple of 16.

“I don’t think there’s a pound-the-table valuations story for why people should be piling into the megacap tech names,” said Donabedian. “I actually still think that over the back half of the year that this value/cyclical trade will probably reassert itself as market leadership.”

Others share his reservations. Mutual funds have, on average, been underweight the Faamg group since 2016 and currently have near-record low levels of exposure, data compiled by Goldman Sachs Group Inc. show. But this stance cost them dearly in 2020, when tech stocks were all the rage during the lockdown.

To Faamg fan Deshpande, a recent hawkish shift in Federal Reserve monetary policy adds another reason to favor the tech leviathans and companies that tend to generate stable sales growth even as the economy slows. He advised investors to trim holdings in industrials.

Faamg’s “valuations have come in so we don’t need to have crazy growth numbers” to justify the prices, he said. “If you look at the cyclical stocks, they’re pricing in a very robust recovery that might have been OK before the Fed turned hawkish. But whatever recovery you were expecting is likely to be not as strong.”