By Denny Fish, Portfolio Manager / Research Analyst
Just a year ago, when reports first emerged of a novel coronavirus outbreak in Asia, few could have predicted the duration and level of economic and societal disruption the pandemic would wreak. Despite all that has occurred, we believe the technology mega-themes that are guiding the global economy toward a digital future not only remain intact, but have even accelerated in some cases.
Pre-eminence of the Cloud
Just as clouds can bring needed moisture that enables ecosystems to thrive, the digital cloud allows other transformational technologies to flourish. The efficiency gains in terms of scalability and analytical capabilities brought by the transition to cloud computing are what’s unleashing the power of artificial intelligence (AI), the Internet of Things (IoT) and, more recently, the rollout of 5G connectivity.
While each of these secular themes will play out over years, in 2020, the cloud was put to the test. As societies locked down, companies scrambled to maintain customer engagement and back-office operations. In this initial “reactive” stage, companies undertook a real-time war game of determining how the cloud could help them maintain business continuity in a remote-work environment. Those that were lacking raced to adopt cloud-based applications, while many others with little to no digital footprints failed.
Companies have now entered what we consider a more “proactive” stage of pandemic-driven digital deployment. With expectations of a hybrid structure of remote work growing and an ever-greater number of commercial transactions occurring online, management teams are now tasked with adjusting their business models to thrive in this new environment. Such changes in processes can take several years to implement, meaning the recent bump in demand for remote-enabling cloud services is far from ephemeral. The durability of the cloud as an investment theme is evident by the fact that even with this year’s material increase in usage, cloud penetration still remains at less than a quarter of its market opportunity.
Peering into 2021 – and beyond
We believe that the most consistent way to generate excess returns within technology investments is to identify the best companies with cutting-edge technologies that will help redefine commerce and social interaction over a three- to five-year horizon. While the future remains bright for our favoured secular themes, 2021 stands to be promising for cyclical growers as well. These tech companies are more exposed to economic cyclicality and therefore should benefit from a reopening of the global economy. Importantly, despite their cyclical nature, companies such as chipmakers and payment processors are also beneficiaries of this digital sea change as we expect their cyclical lows to be incrementally higher as their products proliferate through the global economy.
We also expect 2021 to be favourable for companies that stand to benefit from a return to normalcy. Online dating platforms, for example, were surprisingly in demand during lockdowns and we expect their prospects will only improve as people once again grow more comfortable with in-person dating.
While the cloud came to the fore during lockdowns, we believe the pandemic has catalysed management teams to identify ways to integrate AI into both front- and back-office functions to improve business resilience. Less directly impacted by the pandemic are other mega-themes. The ability of IoT to collect data, which can then be stored and analysed by an AI-enabled cloud, steadily grows. This should be complemented by the rollout of 5G. While this is a gradual process and many consumer applications are yet to be determined, its promise of automating and optimising manufacturing is on a faster track.
Trusting one’s compass
For much of the past year, equity markets were dominated by secular growth stocks. More recently, as optimism surrounding a COVID-19 vaccine has risen, so have the prospects of cyclical tech stocks. The tension between these two categories still exists. We recognise that valuations in certain secularly driven tech subsectors have gotten extended. On the other hand, the promise of an economic reopening is getting priced into cyclical growers. Risks are present for both. Should the economy successfully re-open and interest rate expectations creep up, valuations of long-duration growth stocks could be negatively impacted. Conversely, if weakening data were to continue into the new year, recent gains in cyclical growers could be reversed.
While these risks are not our base case, they should be on investors’ radar. We believe the best way to navigate them is to set one’s compass toward what we consider to be the true north of tech’s future as defined by the secular themes of the cloud, AI, IoT and 5G connectivity. There is, however, a place within a tech allocation for cyclical growers and the key to consistent returns is striking the right balance between the two categories. But a focus on the most promising secular growth themes and those companies with the most durable competitive advantages requires only modest adjustments in one’s portfolio to compensate for economic developments and shifting valuations. An allocation concentrated on cyclical forward themes, on the other hand, would require more pronounced repositioning as the economic cycle and market premiums ebb and flow.
