The Gist: (1) Returns on capital (ROC) in excess of the cost of capital show that the Tech sector is overvalued and Energy undervalued. It also implies the S&P 500 could drop to 4,700 should this persist.
(2) Big Oil rewards returns on capital with shareholder-friendly incentives, while Big Tech lacks such alignment, with many incentives unrelated to financial performance.
(3) ROC is now relevant for Big Tech as the industry has grown more capital-intensive. Shareholders dislike capex on lower-return projects that diminish overall shareholder returns. ie XOM & MSFT.
(4) O&G Market Cap as a % of GDP points to real returns of 9-10% per annum for the next decade, beating the S&P 500, in my view.
What's up everyone. Rob here with the Crude Chronicles. Happy New Year. I got an awesome piece today!
Let's jump right in!
Every year, Professor Damodaran of NYU (HERE) does a massive data dump on over 8,000 companies. What I do is true up all that data to the 11 S&P sector levels.
What we find here is that tech is vastly overvalued and energy is vastly undervalued. If this persists, the S&P 500 could drop to as low as 4,700.
The market could possibly be in the process of doing that as we speak with the weak performance in the market since December.
The scatter plot on the left shows on the X axis, we have shareholder value add, which is returns on capital minus the cost of capital.
That drives the Y-axis of valuations or EV to invested capital.
If a sector is able to earn more on their capital base than what it costs that sector will get a higher multiple because they are creating value.
And vice versa
It has a good R-squared of about 0.70x. Energy is way below the trend line, and tech is above it.
I'm not saying tech doesn't create value. I'm saying the multiples they are assigned are significantly higher than fundamentals suggest, and on the right chart, we see the effect it is having on the market as a whole.
However, there is a wide gap between the two, and this irrational exuberance could imply the S&P 500 falls to 4,700 if valuations fall back to fundamentals.
How has this happened?
Simply examine the incentive structures that have been in place for this to occur.
The point I make in this next slide is that big oil has a much more shareholder-friendly compensation structure than big tech.
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