The underperformance of global tech stocks this year has led some investors to wonder how the businesses that are said to be the lifeblood of the digitizing global economy can quickly become obsolete.
In times of underperformance, investors may want to revisit industry themes and accumulate points based on their allocations to see if anything has changed.
This question requires qualification: what has changed What about a three to five year time horizon? Our answer: Very little.
See: The head of the US Federal Reserve warned that there is ‘pain’ in reducing inflation
We believe that the declining economy not only presents challenges that cannot be ignored, but also opportunities that can be exploited by the most innovative companies.
The forces of high rates and inflation are irresistible
For much of this year, macroeconomic drivers have weighed on tech stocks as investors assess headwinds such as inflation, rising costs and a potential economic slowdown.
This is a year of transition, with the sudden end of a very comfortable policy era.
With interest rates rising, growth stocks with tech-enabled, secular themes have come under pressure because higher rates reduce the future value of their cash flows.
Later, cyclical-growth technology stocks lost ground, closing in on the possibility of economic weakness.
In the short term, macro (e.g., rates and inflation) and cyclical (e.g., valuation multiples) factors can have a significant impact on equity performance.
However, over the long term, we believe fundamentals are the ultimate determinant of investment returns.
In our view, the companies most capable of delivering exciting results on these long horizons are those that are moving into artificial intelligence, the cloud, the Internet of Things (IoT) and 5G connectivity.
A segmented market
Many of the tech companies that have performed best this year are older names with less exposure to the aforementioned secular themes.
Low-growth stocks usually have a low price/earnings (P/E) ratio, meaning they are less exposed to fluctuations in interest rates. In contrast, most secular growers tend to command higher P/E ratios.
Recognizing that any stock can be overheated, we believe many global growers should command higher relative valuations given their unprecedented ability to grow their collective total corporate earnings.
However, during a bullish period, these stocks may underperform due to the method used to reduce their cash flow.
Importantly, many of these companies continue to show strong fundamentals, something that is reflected in recent earnings reports, broadly speaking, better than feared.
One of the takeaways from the current earnings season is that the unit economics of many of the sector’s strongest and most innovative companies remain strong and healthy balance sheets.
A company’s underperformance is, in many cases, the result of prior successes. After their stellar run ended at the start of the Covid-19 pandemic, e-commerce stocks lost a lot of steam.
As far-fetched as it may seem, prior to 2020, online shopping was a much smaller portion of overall consumer activity. Given the rapid adoption of online shopping during lockdown, the direction of the broader economy now has a greater impact on the revenue prospects of these companies.
Accordingly, signs that high inflation is affecting impulse purchases have put heads on e-commerce platforms that they have not been able to deal with before.
A similar phenomenon has affected Internet stocks. Online advertising accounts for about 60 percent of the total advertising market.
As the economy slows down, internet platforms are now feeling the force of reduced advertising budgets more than when there were smaller players in the space.
Once the cloud clears
Inflation forced the Federal Reserve to accelerate its tightening, to the point that a slowdown in growth became inevitable.
Higher rates could keep the prices of global-growth stocks under pressure, and economic softness could dampen the earnings prospects of more cyclical companies.
E-commerce and semiconductors seem vulnerable. The software works as well, but weak orders can be offset to some extent by customers looking to use the cloud to increase efficiency and protect margins.
Central to the “growth cycle” is the narrowing of the company’s operating peaks and troughs as these businesses’ products become more widely deployed.
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Semiconductor companies exemplify this evolution as they benefit from ever-increasing chip content in the economy. Still, higher capital costs and supply chain rationalization have the potential to reduce ever-increasing chip-specific capital costs.
So far, the semiconductor complex has held up relatively well, except in consumer-oriented areas.
In times of turmoil, it is important to ask which business models will be stronger once we get to the other side. We believe that global growth companies will continue to drive productivity and convenience in the economy.
Like other sectors, the economic cycle, rates and inflation matter to technology. A combination of excessive liquidity and enthusiasm can drive prices unsupported by fundamentals.
Both technology sector management teams and investors are in the same boat as they face these risks, which means they need to focus on how technology can be increasingly used and how it can deliver attractive financial results.
Denny Fish is a portfolio manager at Janus Henderson Investors, a member of the Gulf Capital Markets Association.
Updated: September 20, 2022, 4:00 am