by Denny Fish – Portfolio Manager / Research Analyst
Throughout last year’s recession and the ensuing recovery, many equity investors felt compelled to chase near-term, macro trends or investment factors that sometimes ran counter to a company’s fundamentals. Given the unfolding of events – a global pandemic, massive policy response and the accelerated approval of vaccines – it’s understandable that a succession of headlines held sway in markets.
Such an approach, however, is no substitute for identifying well-run companies that can consistently deliver earnings growth over the long term. With additional milestones being achieved in the battle against COVID-19, we believe that this is an opportune time for technology investors to refocus their attention on a company’s financial and operating performance as we expect these are now supplanting macro factors as the major drivers of sector returns.
The cart before the horse
A case in point is this year’s brief love affair between some tech investors and value stocks. Beginning with the approval of the first coronavirus vaccines in late 2020, many investors were drawn toward deep-value stocks, believing low multiples in a reopening economy and a rising-rate environment were sufficient to initiate a durable shift in market leadership. Although rising interest rates would impact the value of future earnings streams of tech companies aligned with secular-growth themes, investors simplistically substituted valuation math for a fundamental understanding of a company’s business model.
We believe that, even with valuations above historical averages, many tech and Internet companies have room to run given their powerful network effects and the role they play in bringing about a digitised global economy. Conversely, several deep-value stocks caught up in the early-year rally still face daunting secular headwinds that have not gone away.
Misplaced concerns
In addition to the expectation of a sustained rotation toward value, the secular-growth tech stocks that dominated 2020 also came under pressure over the winter on concerns about difficult year-over-year comparisons. These worries have largely abated. Once recognising that 2020 fit the definition of a statistical outlier, the Internet, e-commerce and cloud companies that helped the global economy navigate last year’s lockdowns continue to deliver impressive financial performance. We believe that challenging 2020 comparables exist, but they are more reserved for companies that face negative transformational headwinds yet benefited from a one-off boost in business during the pandemic. Desktop computer companies that enjoyed an unprecedented replacement cycle as employees transitioned to remote work come to mind.
Disruption to continue
We remain enthusiastic about the disruptive potential of technological advancement exemplified by the themes of cloud computing, the Internet of Things (IoT), artificial intelligence (AI) and 5G-enabled connectivity. While the adoption of some of these technologies accelerated during the pandemic, we believe that last year was a preview of things to come, and as technology becomes even more interwoven into individuals’ and companies’ daily lives, the sector’s share of overall corporate earnings should increase.
Over the nearer term, the global economic reopening has been iterative, dictated to a degree by vaccination rates. Regional disparities have resulted in suppressed levels of cross-border commerce. Acutely affected by this are digital payments processors. Looking past this delay, we still believe this industry will be a key beneficiary in the next phase of economic reopening.
Other tech segments exposed to the ebbs and flows of the economic cycle are already benefiting from expectations of increased commercial activity. It’s important, however, to differentiate between ordinary cyclical companies (e.g., certain computer and equipment manufacturers) and cyclical growth companies (e.g., semiconductors). The latter category – while still influenced by the economic cycle – finds itself on the right side of the digital divide, and should experience higher “lows” and higher “highs” with each successive cycle. Cyclical companies not leveraged to major disruptive themes may find themselves on the opposite trajectory.
A positive outlook – but not without risks
Mounting regulation is a risk worth monitoring. Within the US, candidates for increased scrutiny are Internet companies with massive market share and considerable market power as illustrated by their ability to extract excessive tolls or give preferential treatment to their own products. In China, behaviour that may catch authorities’ attention is more broadly defined. That has been in display in recent weeks as the central government appears to be flexing its regulatory muscle.
We are less concerned about inflation pushing up interest rates to where they weigh on growth stocks. In fact, we consider the disinflationary nature of technology as a counterbalance to other forces pushing prices higher.
