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Why This Hardened Market Skeptic Thinks a Famous Tech Stock Index Is Still a Good Buy

January 13, 2017, 11:00 AM UTC
A visitor walks through the new lobby at the Nasdaq stock exchange in Times Square in New York, NY, Friday, December 19, 2014.Photograph: Victor J. Blue
A visitor walks through the new lobby at the Nasdaq stock exchange in Times Square in New York, NY, Friday, December 19, 2014. Photograph: Victor J. Blue
Photograph by Victor J. Blue — Getty Images

The Nasdaq is roaring once again.

But after this historic surge, can the tech-and-pharma-laden index really remain a decent buy? The surprising answer, from this hardened market skeptic, is a cautious yes.

Although the possibility of Dow 20,000 is getting most of the buzz, it’s the Nasdaq Composite that is actually leading the charge in shattering records. The Nasdaq welcomed the new year by notching all-time highs on five successive trading days, culminating in a close of 5,563 on January 11. In the past 12 months, it’s jumped 22.9%, edging the S&P 500’s gains by 2.6 percentage points.

Given the recent run, it’s hard to believe now that it’s been 16 years since the Nasdaq first topped 5,000, in March of 2000 at the peak of the dotcom craze. The index then rapidly collapsed, sinking 78% to 1,108 by September of 2002. Many observers, including this writer, reckoned it would take decades for the pummeled index to rescale the mountain to 5,000. Now that the Nasdaq has exceeded that milestone once classified as bubble territory again––an area medieval mapmakers might have labeled with the warning “here lie dragons”––it’s a good time to examine the differences between the index’s composition today and the notorious Nasdaq of 2000.

The biggest difference is the earnings investors are getting for every dollar they invest. In 2000, the Nasdaq’s price-to-earnings hit a dizzying 150.

The problem was two-fold. First, its big-cap components of the index, a group that included, and still includes, Microsoft (MSFT), Cisco (CSCO), Qualcomm (QCOM), Oracle (ORCL), and Amgen (AMGN), were all selling at towering multiples. Second, the Nasdaq was loaded with telecom and networking companies that had little or no earnings, like Worldcom, and in the end went bust.

By contrast, these days the P/E of the hundred largest stocks in the Nasdaq stands at just over an average of 26, or about one-sixth of where it was a little over a decade and a half ago. It also almost exactly matches the multiple for the S&P 500. To be sure, both indexes are pricey by historical standards. But the Nasdaq is clearly the better buy. And I will tell you why.

The reason is basic: The Nasdaq offers the prospect for far faster profit growth. Consider the third quarter, the most recent quarter for which data is available. (The fourth quarter is over, but companies have not reported their results yet. And I don’t believe in trusting analysts estimates. Remember, I am a skeptic.) On average, the profits per-share, after adjusting for one-time events, according to Bloomberg, for the largest 100 companies in the Nasdaq rose nearly 22% in the third quarter, versus a year ago. That’s pretty astounding, given that the U.S. economy’s overall growth is stuck somewhere between 2% to 3%. The S&P 500 had a pretty good quarter, again adjusted for one-time events, of an increase of 16%, according to Bloomberg’s numbers, after a string of lackluster growth quarters. But if you were going to buy all the stocks in the S&P 500, versus all the stocks in the Nasdaq (which you can do with ETFs pretty easily these days) you would be paying the same price for a roughly a quarter less growth.

You could argue that the market thinks that there is something special about the S&P 500 that is worth paying up for. But as a skeptical investor, I don’t buy it. I buy cheap. Buy the Nasdaq.

Here’s my one skeptical caveat. You can’t always count on high growth alone to produce investment returns. It’s important to note that the companies that made up the Nasdaq back in 2000 were growing their profits even more mightily than today. Nonetheless, many of their share prices have generally performed poorly since. Cisco’s shares, for instance, have dropped on a split-adjusted basis to a recent $30, from 69 back in 2000. Intel recently traded for $37, down from $62 at the start of the millennium. Microsoft, one of the best performers of the group, went from $48 to $65, but that’s over 16 years, for a paltry compounded annual return of 1.9%. You would have done better, much better, in low risk bonds.

But here’s the difference. Today, the P/Es of those companies are generally in what even a skeptic would call moderate range with Cisco at 14, Intel at 17.5, Qualcomm at 17, and a Microsoft, of which investors are more excited about then they have been in years, standing at 30.

The last, and perhaps the biggest reason, I would put my money on the Nasdaq has to do with healthcare stocks. In the last year, pharma stocks, of which there are 18 in the Nasdaq 100, have taken a beating. They first sold off because of negative rhetoric during the presidential campaign about drug prices, and took another leg down when president-elect Trump assailed what he views as the industry’s excessive prices in his January 11 press conference. But the Nasdaq index overall hit an all-time high that day despite of the drop in drug stocks. Put simply, drug stocks have gotten a lot cheaper, yet the industry is on the cusp of an M&A boom that could push their prices far higher (the fact that the stocks are cheap will help that), and propel the Nasdaq to fresh records.

What’s more, Trump’s plan to grant companies a tax holiday for repatriating overseas profits should prove a major catalyst for new pharma deals. Along with tech, drug companies have the biggest share of earnings parked overseas. A flood of cash returning from abroad will held bigger drug companies like Gilead (GILD), Pfizer (PFE) and Eli Lilly (LLY) replenish their pipelines by purchasing smaller pioneers with lucrative therapies already on the market or nearing approval. The Nasdaq is flush with such mid-sized innovators. The long list includes Incyte (INCY), purveyor of bone marrow cancer therapy Jakafi, and oncology pioneers Exelixis (kidney and thyroid cancer) and Tesaro (ovarian cancer).

The Nasdaq is a hotbed of creative destruction, where big bets fall flat, but unknowns fill the void by surging to superstardom. In 2000, it was literally impossible for the Nasdaq to grow profits remotely fast enough to be worth the 5,000 it was trading at then. Today, however, even at 5,563, packed with companies with immense potential at reasonable prices, for investors, the Nasdaq’s the place to be.