Why the tech sector should be getting more likes
Why the tech sector should be getting more likes
Enthusiasm for the technology sector has cooled dramatically in recent months. Tech was a star performer during the pandemic as investors poured money into companies benefiting from the shift towards a digital economy. The sector also got a boost from ultra-low interest rates and high levels of retail investor participation, especially in the US.
These factors started to reverse late last year. As Western economies reopened, investors rotated out of technology into more cyclical sectors, such as financials and energy. Rising interest rates, which have traditionally prompted investors to gravitate towards more economically-sensitive sectors, accelerated the trend. The picture has not significantly changed following Russia’s invasion of Ukraine, with inflation set to rise even further and central banks continuing to signal rate rises ahead.
Valuations of some of the fastest-growing areas in tech have more than halved, and in many cases are now back to where they were in 2019. However, we think that technology’s underperformance could soon be coming to an end.
Tech’s outperformance is waning
Performance of S&P 500 and Nasdaq Composite, rebased to 100
Past performance is not a guide to future performance.
Source: Refinitiv Datastream
The sector looks well positioned to navigate the economic challenges emerging from the Russia-Ukraine conflict. Exposure to the region is generally low. And the largest tech companies are awash with cash on their balance sheets – ensuring access to capital for investment and innovation, as well as share buybacks and M&A.
How will inflation impact the tech sector?
Technology should also be relatively resilient in a more inflationary environment. Many industries are likely to see margins suffer as a result of both higher commodity prices and staffing costs. Tech firms, on the other hand, are generally not big consumers of raw materials and employ relatively few people per dollar of revenue. In fact, in previous episodes of inflation there has been stronger demand for technology services which can help companies deal with higher costs.
There’s another driver of recent inflation that bodes well for technology demand: the geopolitical fissures threatening East-West trade routes. Companies were already investing more in local production to make supply chains more resilient – one example being Taiwan Semiconductor Manufacturing Co’s plans for chip factories in Arizona. Any new factory will need a suite of technological infrastructure to maintain its competitiveness with suppliers based in Asia. Companies supplying the software and hardware to enable automation and robotics should consequently benefit from strong tailwinds.
What about growth?
For the first four years after the Great Financial Crisis of 2008, the tech sector moved ahead slowly. But something changed in 2012 as a new model for the delivery of software emerged: “Software as a Service”. This entailed a shift of computing function away from your computer and into the “cloud” – essentially a colossal data centre somewhere in the desert. The cost benefits of renting software and computing power over the web, rather than owning, are substantial.
There are still significant opportunities ahead: Microsoft estimates that only 20% of companies, big or small, have made the switch. Andy Jassy, the new CEO of Amazon and architect of its AWS cloud operations, observes that cloud still makes up only 5% of global IT spending. He believes this is going to increase substantially in the coming years, accelerated by a wave of demand for artificial intelligence and data analytics. The winners in this space are likely to be the largest players, as smaller providers will simply be unable to keep up with the innovation of Amazon, Microsoft and Google.
These “secular” growth stories could well start to look more appealing to investors if global growth estimates fall, undermining the allure of more economically-sensitive sectors such as banks and natural resources.
Buy when others are fearful
The tech sector has recently ranked least favoured in fund manager surveys. But we think the recent fall in valuation creates an opportunity and have been adding to our exposure.
One example is Nvidia, a US-based semiconductor designer. Analysts following the company have raised 2022 profit forecasts by around 20% in recent months – but the shares have also fallen by close to 20% this year. In other words, the stock has “derated” by one third. The company is seeing huge growth in demand as it provides high-powered chips for data centres. It is also helping to power the nascent market in artificial intelligence, with autonomous vehicles the most obvious use, and graphics-rich experiences in the metaverse.
Another company we like is Adobe, the creative services software provider. It’s a nearly 40-year-old company, and since becoming a cloud service provider in 2013 has been growing revenues 15% to 20% every year. It is still on track to deliver 15% sales growth this year with 45% operating margins. It too has seen its valuation fall in recent months. Adobe now trades at the same multiple it did in 2018, when interest rates looked like they were heading to 3% (compared to today’s expectation closer to 2%). This suggests to us that the sector’s interest rate-led derating may have run its course.
Tech’s share of the global economy has expanded rapidly over the last decade and we expect this will continue – even as the tailwind of the pandemic abates. Indeed, Microsoft’s CEO Satya Nadella sees IT spending doubling from 5% of GDP to 10% over this decade. As ever, the key to success is being selective. The recent difficulties at Meta (parent company of Facebook) are a reminder that many of the biggest tech companies are now maturing – and may in turn see their business models “disrupted” by newer rivals. Some companies will grow old gracefully and find fresh momentum – such as Microsoft or Adobe. Others may not age as well. Even so, the sector’s recent performance and attractive valuation suggest that it is becoming an increasingly fertile hunting ground for stock pickers willing to take the long-term view.
The securities referred to in this article are for illustrative purposes and are not to be considered a recommendation to buy or sell. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.