Goldman Sachs: US technology stocks have no "valuation risk", but there is "concentration risk", suggesting diversified investments

As concerns about the capital return of AI gradually emerge, the market's enthusiasm for technology stocks seems to be heading towards differentiation.

In a research report released by Peter Oppenheimer and Guillaume Jaisson of Goldman Sachs on September 5th, they mentioned that while the fundamentals of the technology industry are strong, there is a high concentration risk. They recommend seeking diversified investments, which can not only reduce concentration risk but also allow investors to capture growth opportunities in other industries being driven by AI technology while enjoying the growth of the technology sector.

Technology stocks have not yet formed a bubble, valuations are within historical reasonable range

The report indicates that since the end of the 2008 financial crisis, technology has been the most important driver of global stock market returns, with profits surpassing other major industries such as media and telecommunications. Considering the strong profit growth of technology stocks, their outperformance compared to the broader market is relatively reasonable.

Data from the report shows that since 2008, earnings per share (EPS) in the global technology industry have grown by about 400%, while the average growth rate in other industries is only around 25%.

Furthermore, the report also states that many historical experiences suggest that the technology behind speculative periods has proven to be transformative—bringing significant secondary innovations, new products and services, and profound social changes to our lives, work, and consumption patterns.

However, the market's excitement for new technologies can often evolve into excessive enthusiasm, potentially leading to investment bubbles. A recent study found that out of 51 major technological innovations introduced between 1825 and 2000, 73% of cases exhibited significant stock price bubbles.

Nevertheless, Goldman Sachs believes that artificial intelligence has not yet become a bubble.

The report points out that the current valuation of the AI industry is far below typical valuations of other recent bubble periods, including the Nifty 50 bubble in the early 1970s, the Japanese bubble at the end of the 1980s, and the technology bubble in 2000.

Data also shows that the median price-to-earnings ratio and enterprise value (EV)/sales of the Mag 7 companies are only half of the top 7 companies during the dot-com bubble in 2000. Additionally, the current leading companies are more profitable and have stronger balance sheets compared to those leading during the dot-com bubble.

The report states:

Radical new technologies often attract significant capital and competition, but not all events end in massive bubbles. Most end with a downward adjustment in industry prices as returns revert to moderate levels.

Ultimately, emerging technology markets often consolidate under a few big winners, with growth opportunities shifting towards secondary innovations or products and services derived from that technology.

The capital return of AI is not as worrisome as it seems

Although the current leading companies are profitable, it is important to realize that the leading AI companies today are no longer light-capital enterprises. They require continuous high capital investment, which may even stifle the high return advantage of the industry over the past 15 years.

This has always been a topic of heated discussion in the AI field: high capital expenditures vs. AI technology that has not yet been truly commercializedAlthough capital expenditures remain high, the Goldman Sachs strategic team believes that the return on capital is not as concerning. During the peak of the technology bubble, the proportion of capital expenditures and R&D expenses of TMT stocks to operating cash flow (CFO) exceeded 100%. Today, this ratio for TMT stocks is only 72%.

Furthermore, Goldman Sachs also believes that the significant increase in capital expenditures may actually lead to strong returns.

For example, from 2013 to 2016, Microsoft heavily invested in capital expenditures to build Azure. At one point, Azure had a negative gross margin, but later became hugely profitable.

Compared to Azure, Microsoft's generative AI has a faster profit growth rate (annualized $0.5-6 billion), with the former taking about 7 years to reach a comparable level.

In other words, despite the sharp increase in capital intensity of leading AI companies, their revenue has rapidly reached a level comparable to the Azure period.

Concentrated risk is high, suggesting a focus on the ETC theme

Data from the report shows that although the valuations of top technology companies are not as high as those of other bubble period top companies, their market share is the highest in decades, accounting for 27% of the total market value of the S&P, indicating an unprecedented high concentration.

The report compiled data since 1980 on the average total return that can be obtained by buying and holding the top ten stocks within 1-10 years. It was found that while the absolute returns of dominant companies are still good, these strong returns gradually diminish over time, and they often remain robust "compound companies".

More importantly, if investors buy and hold dominant companies while other faster-growing companies emerge and outperform the market, the returns of dominant companies usually turn negative.

Taking all these factors into consideration, Goldman Sachs believes:

1. Dominant companies are unlikely to be the fastest-growing companies in the next decade.

2. Specific risks in the stocks of this index are very high, and diversification can increase returns.

Goldman Sachs found that besides the technology industry, other industries also have companies with high profit margins and investment returns, as well as strong balance sheets, which the report names "Ex Tech Mixers (ETC)".

Specifically, the global ETC list must meet the following criteria:

Market capitalization exceeding $10 billion, high profit margins (EBITDA > 14%, EBIT > 12%, net profit > 10%), high profitability (ROE > 10%), strong balance sheet (net debt/equity < 75%, ND/EBITDA < 2x), low volatility (vol < 50), sustained profit growth over the past decade.

The report's analysis found that ETC's performance over the past year has outperformed the global market, remaining in sync with the "Mag 7", and its valuation is consistent with the average level since 2016, with the trading price premium relative to the world stock market at its lowest level since 2018Specifically, ETC mainly covers sectors including healthcare and biotechnology, banking and financial services, consumer goods and services, robotics and cybersecurity, retro consumer themes, traditional economy and infrastructure