Buying Tech Stocks? Pick Carefully. This Market Has Changed. - Barron's

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Analysts at Morgan Stanley flagged a return-to-normal environment as a considerable headwind to growth for Zoom.

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Growth tech stocks aren’t all the same anymore, contrary to the way the class of stocks was treated earlier in 2020. That means discerning investors will be rewarded relative to those that seek broad exposure to the sector.

After the broad stock-market decline that ended in late March, tech stocks soared as people and businesses operated from home and long-term trends like the use of cloud services, entertainment streaming, and e-commerce, speeded up. Between March 18 and Sept. 2, the NYSE FANG+ Index—home to Facebook (FB) Amazon.com (AMZN), Apple (AAPL) Netflix (NFLX), Alphabet (GOOGL), and Nvidia (NVDA)—rose 124%.

Smaller software companies exposed to areas like the cloud saw similarly spectacular returns. Workday (WDAY), with a market capitalization of $53 billion, rose 106%. Okta (OKTA) gained 125%. CrowdStrike (CRWD), with a $31 billion market cap, rose 273%, while Zscaler (ZS), at $20 billion, rallied 216%.

The correlation of one-month returns between “growth” and “earnings momentum” stocks peaked at a score of 1 in the middle of 2020, according to analysis by strategists at Evercore. That is up from a correlation of just above zero at the beginning of the year, but by late 2020, the correlation had fallen to almost negative 0.2. It has rebounded, but only to 0.6 most recently.

That correlation of 1 meant the two groups of stocks were moving in lockstep. The plunge to negative 0.2 and partial recovery indicates investors are aware that different factors are driving those shares, and have adjusted their holdings in response.

Growth companies are seen as those that are aggressively seeking to take share in a large market, often at the cost of near-term profitability. Earnings momentum companies, such as the FAANG names, are more focused on profitable growth.

“The main idea: Investors will have to be more discerning when choosing Growth and Momentum names,” wrote Dennis DeBusschere, head of portfolio strategy research at Evercore, in a research note. “Purchasing simple factor baskets based on a broad macro call will generate decreasing returns.”

In other words, the common practice of buying growth stocks when the economy looks shaky isn’t as promising a strategy as buying the right ones. “It’s not necessarily a rising tide lifts all boats,” said Dan Ives, tech analyst at Wedbush Securities.

DeBusschere noted that “quarantine stocks,” or those that benefit most from increased lockdowns and usage of at-home services, excluding the FAANGs, underperformed the FAANGs by 4.3 percentage points Tuesday.

The NYSE FANG+ Index rose 1.8% Tuesday. Several of those stocks, which have been hammered since Sept. 2, are now trading at more tolerable valuations.

Amazon , which rose 1.6% Tuesday, now trades at about 72 times next year’s projected earnings per share, below its 5-year average of 92 times. Earnings growth is solid and investors are buying the dip.

Zoom (ZM), on the other hand, fell 15% on Tuesday after the videoconferencing company reported stronger revenue and earnings than Wall Street expected. But the company gave forecasts indicating year-over-year revenue growth will slow, and analysts at Morgan Stanley flagged a return-to-normal environment as a considerable headwind to growth.

Zoom is by no means cheap. Its enterprise value is about 43 times sales on a forward one-year basis. The average for software-as-a-service companies is less than 30 times, according to Mizuho analysts.

The stock is up more than 500% year to date.

Strategies for potential mergers or acquisitions are another differentiator within tech. The playing field among cloud companies is wide.

Salesforce (CRM) just announced it is purchasing Slack Technologies (WORK) for $27 billion in cash and stock. Ives emphasized that Salesforce is looking to add a workplace-collaboration product to its suite of software offerings for businesses. Microsoft (MSFT) has done this with its Teams platform, and Slack has had a difficult time competing. Slack rose 83% between March 18 and Sept. 2, underperforming many tech stocks.

Ives expects more deals in software, creating opportunity for investors.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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