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Tech Earnings Matter More Than Ever as the Bubble Deflates

Tech Earnings Matter More Than Ever as the Bubble Deflates

(Bloomberg) -- Investors in technology companies are focused more than ever on profits, following an era when low interest rates drove a speculative frenzy in money-losing companies.

Unprofitable companies have underperformed this year and are likely to continue doing so, investors say. A slowing economy and the threat of recession make their stocks a riskier bet than usual, suggesting that the unwinding from the peak of pandemic-era speculation may not yet be done.

A basket of money-losing tech companies compiled by Goldman Sachs Group Inc. has plunged 57% in 2022, including a drop of 0.3% on Monday. To compare, an exchange-traded fund focused on dividend-paying companies in the industry has fallen 22% on a total-return basis, and the Nasdaq 100 Index has dropped 32%.

The Nasdaq 100 rose 0.1% on Monday.

The drop has come as the Federal Reserve aggressively raises rates to fight inflation, a headwind to stocks that are priced on their prospects far out in the future. Goldman’s basket sank 6.7% on Friday, after a strong jobs report underlined that the Fed is likely to remain hawkish. The yield on the 10-year U.S. Treasury note has jumped to almost 3.9%, more than double where it started the year.

“Profitability has become much more important,” said Anthony Saglimbene, chief market strategist at Ameriprise Financial. “There may come a time where unprofitable companies outperform again, but I don’t think Fed policy or the market backdrop will favor them anytime soon. I think they’re in for more pain until we see inflation moderate and the Fed slows its pace of hikes.”

He favors companies with stable businesses and high visibility into profit streams, including Apple Inc., Microsoft Corp., Visa Inc., Mastercard Inc., and Nvidia Corp.

The focus on profitability represents a sharp about-face from pandemic-era trends, when ultra-low rates and economic stimulus fueled outperformance in hyper-growth stocks. Goldman’s basket soared more than 400% between a low in March 2020 and a peak hit less than a year later. It has since dropped 73% from the high.

Among the unprofitable companies with the biggest stock declines this year are Unity Software Inc., Okta Inc. and Asana Inc., all down 68% or more.

While the selloff has compressed price-earnings multiples, many unprofitable tech companies -- notably high-growth software stocks -- continue to trade at sky-high valuations. According to KeyBanc Capital Markets, software valuations remain above average in terms of enterprise value to free cash flow.

In another risk, many unprofitable companies offer stock-based compensation packages to employees. This has become a headwind amid the market’s decline, as companies either have to issue more shares to keep talent, which dilutes the stakes of other investors, or they have to pay more in cash, a further drag on the bottom line.

“There’s been a complete 180 in the market backdrop compared to 2020, with rates going up and the economy slowing,” said Patrick Burton, a portfolio manager at Winslow Capital Management, which oversees about $26 billion. “Not only has the cost of capital skyrocketed and the math stopped working for stock compensation, but these companies should see slower growth. That makes us think they have more room to drop.”

Burton favors tech giants like Microsoft, Amazon.com Inc., and Alphabet Inc., and said some chipmakers had become attractive given their year-to-date weakness.

“We wouldn’t branch out into unprofitable tech,” he said. “Eventually, high-growth unprofitable stocks will come back, but we don’t expect that for a long time.”

Tech Chart of the Day

The collapse in Meta Platforms Inc.’s stock shows no sign of stopping. The Facebook parent closed Friday at its lowest since January 2019, extending a slump that has erased 60% -- and about $577 billion -- off its market value this year. Last week’s drop of 1.6% represented its fourth straight negative week, and it stood in contrast to the gains posted by Apple, Microsoft, Amazon.com, and Alphabet, as well as social-media peers Pinterest Inc., Snap Inc., and Twitter Inc.

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(Updates to market open.)

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