by Denny Fish – Portfolio Manager / Research Analyst
Key takeaways
- Higher interest rates, inflation and the prospects of a slowing economy have proven to be headwinds for the tech sector in 2022.
- Paradoxically, many of the sector’s best relative performers are deep-value legacy companies with compromised market positions, while some exposed to strong secular tailwinds have fallen behind.
- We believe that the tech companies ultimately best positioned to deliver strong performance over the longer term are the innovators leveraged to the powerful themes of cloud computing, artificial intelligence, the Internet of Things and 5G connectivity.
Global technology stocks enjoyed a notable rebound in July, but the sector’s underwhelming year-to-date performance may leave some investors mystified about how businesses that are supposedly the wellspring of a digitising global economy so quickly fell out of favour and led broader equities into a bear market. In periods of underperformance, investors may – rightly – want to revisit the industry themes and stock theses underpinning their tech allocation to determine whether anything has changed. We believe this question needs a qualifier: What’s changed over a three- to five-year time horizon. Our answer: Very little. In fact, just as during the pandemic, we believe that a slowing global economy presents not only challenges that cannot be ignored, but also opportunities that can be capitalised upon by the most innovative tech and internet companies.
The irresistible forces of higher rates and inflation
For much of this year, macro drivers have buffeted tech stocks as investors assessed headwinds including inflation, rising rates, a potentially slowing economy and what these mean for corporate fundamentals and stock prices. This has been a year of transition as the era of highly accommodative policy has come to a – perhaps more abrupt than expected end. With interest rates rising to levels not seen in years, many growth stocks aligned with technology-enabled, secular themes came under pressure as rising rates reduced the future value of their cash flows. Later, once central banks got serious in confronting inflation, cyclical-growth tech stocks also lost ground, held down by the possibility of a weakening economy.
Over short periods, macro (e.g., rates and inflation) and style (e.g., valuation multiples) factors can cast considerable influence on equity performance. Over a longer horizon, however, we believe that fundamentals are the ultimate determinant of investment returns. In our view, the companies most capable of delivering attractive results over these longer horizons remain those aligned with the themes that are integral to the ongoing digitisation of the global economy. Chief among these are artificial intelligence (AI), the cloud, the Internet of Things (Iot) and 5G connectivity.
A bifurcated market – in the least intuitive way
Paradoxically, many of the tech companies that have held up best this year are legacy names that have minimal exposure to the aforementioned secular themes. Low-growth stocks typically have low price/earnings (P/E) ratios, meaning they are less susceptible to fluctuations in interest rates. In contrast, many of the secular growers aligned with durable themes tend to command higher P/E ratios. While cognisant that markets and, thus, valuations can get overheated, we believe many secular growers should command higher relative valuations given what we see as their unprecedented ability to account for an ever greater portion of aggregate corporate earnings growth over time. Yet, in periods of rising rates, these stocks can underperform due to the mechanism used to discount their cash flows.
Tech and internet Price/Earnings ratios in 2022
The compression of earnings multiples has been a significant factor in tech returns in 2022 as investors incorporate higher discount rates in stock valuations.
Source: Bloomberg, as of 2 August 2022. P/E ratios are based on blended forward 12-month earnings estimates.
Importantly, many of these companies continue to display solid fundamentals, something on display in recent earnings reports that have been, broadly speaking, better than feared. One of our takeaways from the current earnings season is that for many of the sector’s most resilient and innovative companies, unit economics remain strong and balance sheets healthy.
Growing pains
Where company performance has lagged, it has in many cases – perhaps ironically – been the result of earlier successes. After their meteoric run early in the COVID-19 pandemic, e-commerce stocks blew off considerable steam. While it seems like the distant past, prior to the pandemic, online shopping was a much smaller portion of overall consumer activity, capable of gaining market share throughout the economic cycle as more households were won over by the convenience of these platforms. Given the accelerated adoption of online shopping during lockdowns, the trajectory of the broader economy now exerts greater influence on these companies’ earnings prospects. Accordingly, signals that higher inflation is starting to impact certain discretionary purchases have introduced a macro headwind for e-commerce platforms that they’ve not had to confront in the past. This maturation represents another transition that the tech sector must navigate.
MSCI All-Country World Technology Index earnings estimates by sub-industry
While software stocks have proven relatively resilient in the face of a slowing economy, e-commerce and internet companies that rely upon digital advertising face stronger headwinds than they did earlier in their life cycles.
Source: Bloomberg, as of 2 August 2022.
The same phenomenon has affected internet stocks. Online advertising has risen to roughly 60% of the total ad market. As the economy slows, internet platforms now feel the force of reduced ad budgets much more than when they were smaller players in the space. In addition, these names face secular changes associated with privacy-related issues.
Once the clouds clear
Inflation has forced the US Federal Reserve to accelerate tightening to the degree that slowing growth – or sustained recession – has become a scenario that cannot be dismissed. This represents a headwind for tech. Higher rates may keep secular-growth stocks’ valuations under pressure, and economic softness could hamper the earnings prospects of more cyclical companies. E-commerce and semiconductors appear vulnerable to a slowdown. Software does as well, but weaker orders could be offset to a degree, by customers seeking to leverage the cloud and other applications to increase efficiencies and defend margins – initiatives that are often prioritised during periods of slowing top-line growth. Software’s ongoing transition to cloud-based platforms also means that the associated recurring-revenue models could make them less susceptible to customers’ budget cutbacks.
Central to “cyclical growth” is the amplitude of a company’s operational peaks and troughs narrowing as these businesses’ products are more widely deployed. Semiconductor companies, in our view, exemplify this evolution as they benefit from not only an ever-increasing amount of chip content across the economy but also a long period of much needed-industry rationalisation. Still, a higher cost of capital and supply chain rationalisation has the potential to lower the level of increasingly chip-intensive capital expenditure. Thus far, the semiconductor complex has held up relatively well, with the exception of consumer-focused areas such as PCs, smartphones and memory.
As with other sectors, the economic cycle matters to tech. So too do rates and customers’ appetite for products in the face of generationally-high inflation. The combination of excess liquidity and waves of enthusiasm can also push up valuations to levels not supported by underlying fundamentals. Navigating these broader risks are part and parcel of equities investing. In this sense, both tech sector management teams and investors are in the same boat, meaning they should maintain focus on how technology is increasingly deployed in the global economy and how that translates to delivering attractive financial results.
