Higher interest rates, inflation and the prospect of an economic slowdown have proven headwinds for the tech sector in 2022.
Paradoxically, many of the industry’s relative best performers are deep-value legacy companies with vulnerable market positions, while some exposed to strong secular headwinds are left behind.
We believe that the technology companies that are ultimately best positioned to deliver strong long-term performance are the innovators driven by the strong themes of cloud computing, artificial intelligence, the Internet of Things and 5G connectivity.
Global technology stocks rallied significantly in July, but the sector’s poor performance may have left some investors confused about how companies that are supposed to be the lifeblood of a digitized global economy have fallen out of favor so quickly, sending stocks broadly lower. bear market. In periods of underperformance, investors may – rightly – want to revisit the industry themes and stock theses that underpin their technology allocations to see if anything has changed. We believe this question needs a qualifier: what has changed in the three to five year period?
Our answer: Very little. Indeed, as during the pandemic, we believe that the slowdown in the global economy does not only present challenges that cannot be ignored.
The irresistible forces of higher rates and inflation
For much of this year, macro factors weighed on tech stocks as investors weighed the winds, including inflation, rising rates, a potential economic slowdown and what that means for corporate fundamentals and stock prices. This was a year of transition, as the era of extremely permissive politics ended – perhaps more abruptly than expected. With interest rates rising to levels not seen in years, many growth stocks aligned with secular, technology-enabled themes have come under pressure as rising rates have eroded the future value of their cash flows. Later, when central banks took inflation seriously, cyclical growth technology stocks also lost ground, hampered by the prospect of a weakening economy.
Over short periods, macro (eg rates and inflation) and stylistic factors (eg valuation multiples) can significantly affect stock performance. However, in the longer term, we believe that fundamentals are the ultimate determinant of investment returns. In our view, the companies that can best deliver compelling results over these longer horizons continue to be those that are aligned with the themes that are integral to the ongoing digitization of the global economy. The main ones are artificial intelligence (AI), the cloud, the Internet of Things (IoT) and 5G connectivity.
Split market – in the least intuitive way
Paradoxically, many of the tech companies that have outperformed this year are legacy names with minimal exposure to the aforementioned secular themes. Low-growth stocks tend to have low price-to-earnings (P/E) ratios, meaning they are less sensitive to interest rate fluctuations. In contrast, many secular producers dealing with enduring themes tend to have higher P/E ratios. While we are aware that markets and thus valuations can become overheated, we believe that many secular producers should demand higher relative valuations given what we see as their unprecedented ability to account for an increasing share of overall corporate profit growth over time. However, in periods of high rates, these stocks may underperform because of the mechanism used to discount their cash flows.
Technological and Internet price/earnings indices in 2022
Compression of earnings multiples has been a significant factor in tech’s return in 2022 as investors factor higher discount rates into stock valuations.
Source: Bloomberg, as of August 2, 2022. P/E ratios are based on 12-month combined estimates of future earnings.
Importantly, many of these companies continue to deliver solid fundamentals, something reflected in recent earnings reports that, overall, were better than expected. One of our takeaways from the current earnings season is that for many of the industry’s most resilient and innovative companies, unit economics remain strong and balance sheets remain healthy.
Where company performance has lagged, in many cases – perhaps ironically – it has been the result of past successes. After a meteoric rise at the start of the covid-19 pandemic, e-commerce stocks have fallen significantly. Although it seems like a distant past, before the pandemic, online shopping was a much smaller part of overall consumer activity, which could gain market share over the economic cycle as more households were won over by the convenience of these platforms. Given the accelerated adoption of online shopping during the quarantine, the trajectory of the general economy now has a greater impact on these companies’ earnings prospects. Accordingly, signs that higher inflation is beginning to affect certain discretionary purchases have led to macro headwinds for e-commerce platforms that they have not had to contend with in the past. This maturation represents another transition that the technology industry must go through.
MSCI World Technology Index Earnings Estimates by Subsector While software stocks have proven relatively resilient to the economic slowdown, e-commerce and Internet companies that rely on digital advertising are facing more challenges than ever before in their life cycles.
Source: Bloomberg, August 2, 2022.
The same phenomenon affected Internet stocks. Internet advertising has grown to about 60% of the total ad market. As the economy slows, online platforms are now feeling the pull of reduced advertising budgets far more than when they were smaller players in the space. Additionally, these names face age-old changes related to privacy concerns.
Once the clouds clear
Inflation has forced the US to accelerate monetary tightening as a slowdown in growth – or a sustained recession – has become a scenario that cannot be ruled out. This represents a tailwind for technology. Higher rates could keep valuations of secular growth stocks under pressure, and economic softness could hurt the earnings prospects of cyclical companies. E-commerce and semiconductors appear to be sensitive to the downside. So is software, but weaker orders may be somewhat offset by clients looking to leverage the cloud and other applications to increase efficiency and defend margins — initiatives often prioritized during periods of slowing revenue growth.
The key to “cyclical growth” is the amplitude of a company’s operational peaks and troughs, which diminishes as those companies’ products become more widely used. Semiconductor companies, in our view, exemplify this evolution as they benefit not only from increasing amounts of chip content across the economy, but also from a long period of much-needed industry rationalization. However, the higher cost of capital and streamlining of the supply chain has the potential to reduce the level of increasingly intensive chip capital expenditure. So far, the semiconductor complex has held up relatively well, with the exception of consumer-facing areas such as computers, smartphones and memory.
As in other industries, the business cycle is important for technology. Likewise, fees and customer appetite for products in conditions of generationally high inflation. A combination of excess liquidity and waves of enthusiasm can also push valuations to levels unsupported by fundamentals. Managing these broader risks is an integral part of investing in stocks. In this sense, both technology industry management teams and investors are in the same boat, which means they must remain focused on how technology is increasingly applied in the global economy and how this translates into financial results.