Is VGT A Good Long-Term Buy For ETF Investors?

Someone recently asked me if the Vanguard Information Technology ETF (VGT) was a good long-term investment to buy now that it has undergone a sharp correction. VGT has indeed dropped dramatically YTD, as you can see from the chart below. It has lost over 12% of its value and appears to be on its way to a further decline as investors pull money out of the many profitless companies with nonsensical market caps that were so popular just a year ago.

Of course, to put this correction into perspective, the Tech sector and the Vanguard Information Technology ETF had risen far more dramatically since the Pandemic struck. Even after the correction, VGT’s price on February 19, 2022 is still more than double what it was March 24, 2020. It’s also 47% higher than its peak pre-COVID-19. Those who invested in VGT at any time before spring of 2021 are still sitting on nice profits.

But that information isn’t very helpful to people who are wondering if they should buy VGT now. Is this the kind of temporary dip they should hurry in to buy, or has investing in the Information Technology sector lost its luster?

Before you can answer that question, you need to decide if VGT’s gratifying price action over the past few years was just a temporary side effect of the pandemic and of the enthusiasm of the new investors who entered the market during the pandemic, or if there is reason to believe that the Tech sector still has the potential to outperform.

Let’s examine VGT and its holdings more closely to see if we can answer that question.

VGT Key Metrics

As those of you who follow my writings here on Seeking Alpha know, I pay close attention to valuation metrics when I invest. Yes, I miss out on the big runups for stocks that will take 20-30 years to live up to exuberant speculators’ hopes, but I also don’t end up watching my investments crater when the crowd abandons last year’s fad in order to pile into the latest bright and shiny thing.

But I also understand that you have to be careful when trying to use simplistic valuation metrics to value growth stocks and that the Technology sector is full of growth stocks. The question I have learned to ask, when attempting to apply some kind of crude valuation to an ETF like VGT, is whether the growth history of the stocks in VGT supports the ETF’s current fundamentals.

Of course, since VGT is one of the Vanguard ETFs that is really a share class of a Vanguard Mutual fund, the fundamentals Vanguard provides us are scanty, mysteriously arrived at, and always weeks out of date by the time Vanguard makes them public.

Here are the few Fundamental metrics Vanguard provides us with.

Vanguard Information Technology ETF Fundamentals

These Metrics Aren’t the Ones We Need to Determine If VGT is Over-Valued

From what we are told here we can conclude that VGT holds shares in a lot of stocks, which suggests that it is well diversified within its sector. It also appears that the stocks it holds are fairly large cap stocks as they have a median market cap $378.7 Billion.

VGT’s P/E ratio is also very high at 30.8, even though it has just experienced a significant correction. For reference, the P/E ratio of the S&P 500 right now is only around 23.

VGT’s Price/Book ratio is also extremely high, but Price/Book is not a particularly useful metric for evaluating companies whose most valuable assets may be intellectual property, brand allegiance, or services.

Unfortunately, Vanguard does not report a Price/Sales ratio for VGT. Price/Sales would be a far more useful metric, especially since VGT does not require that a company be profitable to enter its index.

VGT’s apparently high valuation might be justified by the high return on equity Vanguard reports. Even more compelling is its very high earnings growth rate.

But immediately, a red flag should go up. The huge surge in earnings growth we see reported here is not qualified by any information telling us whether it is entirely historical, based on the past year’s earnings growth, or if it also includes short-term estimates of future growth. Other ETF providers do give us this information.

If Vanguard is just reporting VGT’s earnings growth over the trailing 12 months, that growth would still have been heavily dominated by the shift to Work from Home that took place due to the pandemic. But by now employees working from home will have upgraded their home systems and installed the necessary software needed to do professional work from home. So pandemic-driven tech growth is not something we should expect to see continue. Analysts’ expectations for VGT’s future earnings growth would be much more useful, but we aren’t given it.

It is when we look at the information Vanguard gives us about the weight of the individual stocks held by VGT that we realize just how deceiving the metrics Vanguard provides for VGT may be.

The Illusion of Diversification in VGT’s Holdings

Let’s start with VGT’s apparent wide diversification. Vanguard tells us that VGT holds 360 stocks. This, which might make you feel that by investing in VGT you are investing in hundreds of stocks and will benefit if only a few of its smaller holdings turn into the Next Big Thing. But a quick look at the weight of the top 10 stocks in VGT should quickly disabuse you of that belief.

Not only is 60.50% of the Vanguard Information Technology ETF’s total assets under management invested in just 10 stocks, but just two of those stocks make up a full 40.70% of VGT’s total value: Apple (AAPL) and Microsoft (MSFT). This is even more concentration in these two top stocks than the 38.1% they made up back in December of 2020 when I last wrote about VGT.

When you download the complete list of VGT holdings, it becomes very clear that once you get past the top 25 stocks ranked by weight in VGT, the weight of each subsequent stock is so small, that even if some of these stocks are growing their earnings at a rate of 50% a year their success will make very little difference in the performance of VGT.

The 26th stock in VGT is Fidelity National Information Services Inc. (FIS). It contributes only .50% of the value of the whole ETF. The 51st stock is Keysight Technologies (KEYS). It contributes only .25% of that total value. By the time you get to the 101st stock ranked by weight, which is Zendesk (ZEN), you will find it contributes only .09% of the ETF. It is all downhill from there. The last 91 stocks in the ETF each contribute “<.01%” of the value of the whole.

That means for every $1,000 you might have invested in VGT on January 31, 2022, $230 bought Apple stock, $177 bought Microsoft stock, $0.90 bought Zendesk, and you bought less than a dime’s worth of 91 other stocks.

If Zendesk were to grow its market cap by a factor of 10, it would still make up less than 1% of the weight of VGT and its impact on VGT’s performance would be dwarfed by that of Apple and Microsoft.

So you are not buying diversification within the Tech sector when you buy VGT. The future value of VGT depends almost entirely on how some 25 stocks perform in the future and even more so on how three top stocks, AAPL, MSFT, and Nvidia (NVDA) perform.

We’ll take a deeper look at the valuations of those three stocks later, but there is one more issue involving VGT’s metrics to consider before we move on.

VGT is A Sector ETF So You Need to Understand what a “Sector” Really Is and Who Decides what Stocks Go in Which Sector

The “sectors” you hear about when you read investing news are usually those defined by the Global Industry Classification Standard (GICS). VGT tracks an index that only holds stocks found in the GICS Technology sector.

GICS is not an academic institution, nor is it an independent organization. GICS is a joint venture of Morgan Stanley Capital International (MSCI) and S&P Global (SPGI). These companies make their billions serving the institutions that sell you stocks, funds, and ETFs.

GICSs sector definitions are at times ludicrously arbitrary as they are assigned when stocks are young and often not changed when the issuing company’s business model changes. But GICS does change its sector definitions every so often, and when they have done that recently those changes have had a heavy impact on the Tech sector –and thus on VGT.

GICS Assigns Every Stock to a Single Sector in a Way that Defies Logic

The flaw in the way the GICS’s sector definitions work is that each stock, even if it has a trillion dollar market cap and is involved in 27 separate lines of business, can only be assigned to a single sector.

A lot of people might think that Amazon (AMZN) is a tech stock, given that its AWS has become the world’s top Cloud provider and that it also sells a lot of hardware devices like Kindles, Fire tablets, Ring Doorbells and the ever present Alexa devices. But GICS currently classifies Amazon (AMZN) as a Consumer Discretionary stock, and puts it in the same sector as McDonalds (MCD), Home Depot (HD), and Target (TGT).

Amazon does, of course provide a marketplace of lots of hard goods and it also owns a huge grocery chain, Whole Foods. This makes it similar to Walmart (WMT), which also sells a lot of hard goods and food, and which also is growing its online sales presence. But oddly, though Target is in the same sector as Amazon, Walmart is currently a member of the GICS Consumer Staples sector, not the Consumer Discretionary sector.

When we look at what stocks are in the Technology sector we see, again, how arbitrary sector assignments seem to be. Microsoft and Apple lead the GICS Tech sector, though Microsoft also dominates gaming. But other companies that provide similar entertainment services, like Draftkings are in the Consumer Discretionary sector, along with Amazon. In fact, it is placed in the Hotels, Restaurants & Leisure subcategory.

Since Apple’s main business right now is its iPhones and all the entertainment software, videos, music, and books it sells through its App Store, not to mention TV streaming, you could make a good case that Apple might fit into the same Consumer Discretionary sector like Amazon. But it doesn’t.

Meanwhile, Alphabet (GOOG) (GOOGL) is not a Tech stock. GICS classifies it as a Communications Services company, based, perhaps on its being largely an online advertising company. But Alphabet is looking a lot more like Apple lately, what with its being a major player in Cloud services and pushing its Pixel devices, Chromebooks, and Android operating system. And getting back to Amazon, it is making a huge amount of its revenue from selling advertising. So should it be placed in the Communications Services like Alphabet?

GICS’s Real Goal is to Spread Top Stocks Evenly Throughout all Sectors to Maximize the Appeal of Sector Indexes

The point of the previous section is that there are huge inconsistencies in the way that GICS assigns stocks to the different sectors. Their scheme may seem irrational until you realize that GICS’s real goal is not to behave in any rational way, but to make sure there are attractive, popular, very large cap stocks in as many different sectors as possible. This keeps all sectors appealing to investors by boosting their performance.

And this is what gets us back on the topic. VGT is a sector ETF, and because it has, for decades, held so many of the largest and most popular stocks on the market, GICS can’t stop raiding it for stocks to put into some other, lagging sector. More to the point. It is about to do this yet again.

GICS Is About to Redefine the Tech Sector and Wants to Remove Some Top Stocks from VGT

You won’t find this mentioned anywhere on Vanguard’s site, and you would have to be a somewhat obsessive investing hobbyist like me to have noticed this bit of news, but over the past year, GICS has been mulling over some very significant changes to the Tech sector. The changes they have proposed are detailed here. See page 18 for the most important change, being proposed:

Discontinue the Data Processing & Outsourced Services Sub-Industry under the Information Technology Sector and move it to the Industrials Sector. In addition, reclassify transaction and payment processing companies from the Information Technology Sector to the Financials Sector.

GICS Has A History of Moving Hot Stocks From the Tech Sector Into Sleepier Sectors

There is a pattern here that investors need to be aware of, one that goes back long before GICS proposed these current changes.

In 2018 GICS moved Alphabet (GOOG) (GOOGL) and the company previously known as Facebook, i.e. Meta, (FB) out of the Tech sector and placed them into what had been until then the very sleepy Telecommunications Services sector. Before that move, that sector had been dominated by sluggishly growing telecommunications stocks led by AT&T (T) and Verizon (VZ). GICS gave it a new name, the Communications Services sector, moved in Alphabet and Facebook, and made the sector a lot more appealing to investors, while depriving the Tech sector of two of its strongest performers.

GICS’s latest plan to move out more top stocks was hatched early in 2020, before “inflation” was on everyone’s mind. I am tempted to think that the point of moving Visa, Mastercard, Paypal and other Fintech stocks into the Financial sector and the payroll companies into the Industrial sector were attempts to boost the appeal of what were, at the time, two other under-performing sectors.

Some Important Stocks GICS Wants to Remove from The Tech Sector and VGT

Seven important stocks currently in the Tech sector would be moved to other sectors if GICS goes forward with these changes. They include Top 10 stocks Visa (V) and Mastercard (MA) as well as Paypal (PYPL) which would move into the Financials Sector.

It also wants to move payroll companies which would include, Automatic Data Processing (ADP) and Fidelity National Information Services (FIS), Paychex (PAYX) , and Broadridge Financial (BR) intothe Industrial sector.

There are probably many other, small stocks that will move, too.

We Will Know Within Weeks If These Changes Will Take Place and VGT is Likely to Respond Immediately

GICS has been inviting comment on these changes for several months. It even extended the commenting period–suggesting that perhaps the comments they had received during the original comment period weren’t entirely supportive.

But the extended commenting period ended this past Friday, February 18, 2022. GICS has told us that they will make the decision as to whether or not they will make these changes very soon and announce it this March.

If the proposed changes are adopted, the GICS sector definitions, and all indexes that track sectors, will be officially changed in March 2023. What this means for investors in VGT is that, though the sectors will only officially change a year from now, ETFs that track the GICS sectors are likely to adopt a “transitional index” starting as soon as possible. This is a temporary index that allows the ETF to gradually sell off the stocks that are going to be eliminated from VGT over the course of a year, and thus avoid front running.

This Cannibalizing of Top Tech Sector Stocks Is Why You Don’t Want to Hold VGT Long-term

Whether or not GICS ends up changing its sector definitions, this attempt points to the big problem with Tech sector ETFs that track GICS’s sector definitions. As long as the Tech sector is more successful than other sectors, GICS will likely continue to raid its stocks to beef up other, lagging sectors.

If there was any other reason for these changes, you have to ask yourself why GICS isn’t moving Amazon into the Tech sector to better align it with its current business model and moving Walmart into the same sector as Target, Home Depot, and Lowes. It’s notable that those particular changes, which would beef up strong sectors have not been discussed when sector changes have come up this decade.

Note that if GICS makes these changes they will impact every sector ETF that uses the GICS definition of the Technology sector in constructing its index, even if the index is constructed slightly differently from that of VGT. The most notable of these other ETFs is the Technology Select Sector SPDR Fund (XLK)

We Don’t Know What Stocks Will Be in VGT this Year, So Let’s Look at its Very Top Stocks

Since we don’t know what stocks will be held in VGT over this next year or in what amounts they will be held, I won’t attempt to evaluate the 50-100 top stocks by weight stocks that make up 75-80% of VGT’s total value, the way I usually do when evaluating an ETF.

But what we do know for certain right now is that whatever changes are made in the GICS sector definitions, two stocks, Apple, Microsoft, will continue to play a huge part in its future performance. They currently make up a whopping 40.7% of VGT’s total value. Hence we should take a good look at their current valuations and how analysts think they are likely to perform going forward.

I’ll also look at NVIDIA (NVDA) which is the third largest stock in VGT by weight, though it plays a much smaller role in VGT performance than do Apple and Microsoft.

After those three stocks, into which you will be investing $45.60 of every $100 you put into VGT, we start running into stocks that may no longer be in VGT if GICS’s proposed changes take place, making it futile to look at their current valuations.

A Look at Apple’s Current Valuation

Apple is by far the largest holding in VGT. Its stock currently makes up 23% of its total value–almost a quarter. Its tremendous out-performance over the past several years has been a big part of why VGT has performed so well.

But how does it look now? The Fastgraphs chart below should give you a good idea. The black line is Apple’s price. The blue line is the price that would give Apple the P/E ratio that matches its average P/E ratio over the past decade. The orange line represents the P/E that would make sense using the Graham – Dodd formula P/E=Growth rate.

Uneven Earnings and One Super-Boom Year

As you can see, Apple’s earnings growth over much of the past decade has been a bit choppy, with years of dramatically high earnings balanced by years when earnings rose more modestly or even declined. Two years of modest growth began in 2019 and carried through the pandemic year, 2020, only to be followed by a year where earnings grew by an astonishing 71%.

But since 2019, before Apple experienced dramatic earnings growth, Apple’s price shot up. By now it has risen to a level that is very hard to justify, even with last year’s 71% earnings growth. It is even harder to justify Apple’s stock price when you look at how modest analysts’ expectations are for its earnings growth over the next two and a half years. They are predicting single digit growth rates for Apple out to 2024.

Yes, Apple’s investors are an enthusiastic bunch who don’t pay a lot of attention to valuation metrics. And yes, there are dozens of articles published every month here on Seeking Alpha telling you why Apple is a great investment. I don’t begin to be an expert on Apple. Maybe it has yet another amazing invention up its sleeve that no one knows about right now. But even so, I can tell you this:

• If you invest in Apple right now at its current price, you must be assuming that over the next five years it will have far more years with high double digit earnings growth than it does those with the single digit growth characteristic of mature companies.
• If you buy a lot of Apple stock now, as you will be doing if you buy VGT, you must also be assuming that investors will continue to ignore the oh-so-20th-century concept that a stock’s price should have some relationship to the company’s ability to earn profits. Because even double digit annual profits won’t live up to the expectations currently built into its price.

Personally, though I envy everyone who bought Apple years ago, I don’t expect to envy those who buy it now. A year or two of mediocre earnings growth may be all it takes to knock its price back into the reality zone.

Seeking Alpha Quant Scores for Apple

Fastgraphs is not alone in treating Apple as seriously over-valued. Seeking Alpha’s overall Quant Rating for Apple is currently a Hold. Its Quant Factor Grades for Apple are as follows:

Microsoft’s Current Valuation

Microsoft doesn’t play quite as large of a role in VGT’s total performance as does Apple, but with it making up 17.7% of the total value of VGT, its valuation is also extremely important when we are trying to determine how VGT might perform going forward. And as you can see from the chart below, Microsoft’s current valuation is even higher than that of Apple.

Microsoft has been growing its earnings faster and a bit more consistently than Apple has been over the past four years. And unlike Apple, it is expected to keep on growing earnings at a double digit rate for the next two and a half years. But with a current P/E ratio of 32.86, it, too is at risk that a year or two of disappointing earnings could lead to a sharp exodus of investors taking profits while they are still there to take.

As I wrote in my previous article. I like Microsoft, a lot, and I would love to own it, but not at its current price. Yes, that price has come down quite a bit over the past few months, but not enough to begin to make it attractive.

Seeking Alpha Quant Scores for Microsoft

Once again, Seeking Alpha’s Quant Rating agrees with Fastgraphs that Microsoft has gotten way ahead of itself. It has an overall Quant Rating of Hold and the following Quant Factor Grades. That F for valuation should be telling us something.

NVIDIA’s Current Valuation

So far we have been looking at the top components, ranked by weight, in VGT, which make up a full 40.7% of the total value of VGT.

NVIDIA (NVDA) is the third stock listed when stocks in VGT are ranked by their weight in the ETF. At the end of January 2022, NVDA made up a far smaller percentage of the weight of the whole ETF than did Apple and Microsoft, contributing 4.90% of VGT’s value. This, however, is larger than the 3.51% of VGT it represented back in December, 2020 when I last analyzed the holdings in VGT.

That 4.90% weight would make it the top stock in just about any other large cap ETF, but as we have seen, its share is dwarfed by its two trillion dollar market cap companions. Still, NVIDIA’s share in VGT is about 10 times as large as that of the 25th stock in the ETF, which you will remember made up only .50% of VGT by weight. NVIDIA’s share is about 500 times the size of the share claimed by the individual stocks in the bottom quartile of VGT’s holdings when they are ranked by weight.

This is what NVIDIA looks like to Fastgraphs:

As you can see, NVIDIA’s earnings growth rate since 2015 has been extremely high, though somewhat uneven. You can also see how that high earnings growth encouraged investors to assign it an extremely high price/earnings ratio. It has had an average P/E ratio over the past decade of 32.39. This is quite justifiable for a stock whose earnings grew at an average annual rate of 34.16.

But does that growth rate justify its even higher current P/E ratio, which has surged to 54.52? You have to wonder. Especially since that 54.52 P/E represents its price after its share price has fallen 29% from its November 2021 high–despite NVIDIA having achieved two consecutive years of annual earnings growth over 70%.

Analysts are forecasting more modest double digit growth for NVIDIA going forward. Again, I don’t have the specialist knowledge needed to judge whether those estimates can be relied upon. I do however know that any stock with a P/E ratio that high has to keep on dazzling investors or suffer further price deterioration.

Seeking Alpha Quant Scores for NVIDIA

Seeking Alpha’s Quant Rating for NVIDIA is hold, just like its rating for Apple and Microsoft. It’s Quant Factor Grades look a bit better than the other two stocks, but that F grade for Valuation is something to consider.

A Stumbling Economy Could Damage All Three of these Stocks and VGT

This brief survey leaves me with the sense that all three of these stocks are priced for perfection and beyond. That leaves them very vulnerable if the economy contracts, which is something that is very likely to happen at some time in the next couple years if not this year. It also leaves them vulnerable if the rate at which consumers purchase the goods and services they sell retreats to the levels where they were before the pandemic, which is also quite likely.

Bottom Line: VGT Has Had A Fine Run But Is Not the ETF I Want to Hold for the Next Decade

I bought a big chunk of VGT as the recovery from the pandemic swoon got going, and those shares have done very well for me. But after researching VGT this week I came to the conclusion that it was time to do something I rarely do in a taxable account: take some profits–which I did.

The issues that are making me leave VGT are these:

• It’s too concentrated in too few stocks.
• GICS Keeps Taking Away VGT’s Top Performers.
• And finally, it’s current top performers have performed far too well during the pandemic years which makes it very likely they will continue to correct until their prices bear a better relationship with their earnings.