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Apple’s Quarter Shows How Tech Investors Favor Services Growth Over Everything Else

Following mixed earnings by several giants in recent weeks, investors responded with cautious optimism on Tuesday to Apple's latest quarterly results.

Apple's stock rose 4% in after-hours trading after saying its revenue rose 1% to $53.8 billion while profits were $2.18 per share. Both figures slightly beat Wall Street forecasts.

Although the results were modest, investors took them as a positive considering recent concerns about slowing iPhone sales and the U.S.-China trade war. A strategy by Apple to expand beyond devices like iPhones to services such as music and apps appears to be working with sales of Apple devices falling 0.2%, while service revenue grew 13%.

"This was our biggest June quarter ever—driven by all-time record revenue from services," Tim Cook said in a statement.

In that sense, Apple's earnings follow a trend in tech: Services are shoring up growth, while manufactured products are struggling.

"Companies that are more services-oriented are reporting much better results than those levered to the industrial economy," says Michael Reynolds, investment strategy officer at investment-management firm Glenmede Trust. Tech companies that manufacture chips and hardware are lagging this quarter, he says, while "industries like software have been reporting strong figures."

Take Google parent company Alphabet, which posted one of the strongest quarterly earnings in tech this month. The company beat Wall Street expectations for revenue and profits, powered by growth in YouTube and Google's cloud business, which still lags rival Amazon Web Services. A UBS analyst noted Alphabet's earnings "checked every investor box" in a report that suggested further growth on several fronts.

Microsoft also beat analyst expectations, thanks to its cloud-computing business, which added new clients, as did Office productivity software. That performance has pushed Microsoft's stock up 3% since mid-July. Twitter, shares, meanwhile, are up 8% since the company said on Friday that it's growing users faster than expected and doing a better job of squeezing ad revenue from those users.

Those performances stand in contrast to chipmakers like Intel and AMD, which have had to work harder to satisfy investor demands. Both stocks are down since their earnings reports, with AMD's stock off 6% late Tuesday following the company's warning that revenue may disappoint in coming quarters.

Other tech giants had good financial performances overshadowed by other news. Facebook's stock has been erratic since last Wednesday, when it offered good news (better than expected revenue and adjusted earnings) along with the bad (a record $5 billion fine for privacy violations along with a new antitrust probe). Overall, the social-media giant's stock is down more than 3% since its most recent earnings report.

And Netflix is down nearly 11% since reporting that it added 2.7 million net new subscribers in the second quarter, well below the 5 million that analysts had expected. Amazon, meanwhile, has fallen about 5% since warning last Thursday it would boost spending this year to remain competitive in delivery speeds.

Despite those initial sell-offs, some analysts remain optimistic. Netflix and Amazon have faced tough competition before and still managed to push their stock prices higher. Macquarie analyst Ben Schachter said that Amazon's investment in improving shipping speeds to customers could help accelerate revenue growth in coming quarters. "While it will lower margins, we think the increased top-line impact and, perhaps more importantly, the widening of the competitive moat is worth it," he said.

With a decade-long U.S. stock rally looking long in the tooth, investors have responded to tech earnings with a kind of jittery optimism. Glenmede's Reynolds points to the beta of the most popular big-cap tech stocks. When a stock's beta, a measure its volatility and risk, surpasses 1.0, it shows that it's become more volatile than the overall market. According to Reynolds, the average beta of Alphabet, Amazon, Apple, Microsoft, and Netflix is 1.6, "implying approximately 60% more systematic risk than the broader market itself."

The higher volatility in those five stocks may be a sign that investors are crowding into a relatively small number of big-tech stocks that have consistently offered the promise of strong revenue and profit growth. In recent months, they have represented 16% of the S&P 500's market value, a historically high ratio, thanks to a heavy demand for them among growth-hungry investors.

That demand can get out of hand, however, by setting a high bar of expectations for future quarters. "In the past when the top five have represented more than 14% of the S&P 500, those five stocks have lagged the broader index the following three years in every instance, underperforming by an annualized 5.3%, on average," Reynolds says.

So while tech companies that rely on services and software are having a relatively strong earnings season, there's no guarantee that their stocks will keep outperforming the broader market. Safe havens like the tech sector offers in a time of uncertainty are safest when they aren't so popular with investors.

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