by Denny Fish – Portfolio Manager | Research Analyst
Although this year’s rally in technology stocks is welcome, the sector’s underperformance in 2022 still weighs on many investors’ minds. Behind last year’s sell-off was the resetting of interest rates, which cut into the value of growth companies’ expected cash flows.
Another headwind, however, was of the sector’s own making: Interpreting the pandemic-era surge in business as the new norm, several leading tech and internet companies aggressively ramped up capacity in the form of hiring and capital investment. As demand subsided, many of these businesses were left with operational footprints far larger than what was justified by marketplace conditions.
Company managers were likely comfortable with their ambitious plans because they had seen them work in the past. But times have changed. Tech executives in maturing companies – and investors – need to recognize that the invest at all costs mantra that often exemplifies nascent and fast-growing industries no longer applies to them. Instead, these companies need to be run – and judged by the investment community – on more traditional metrics, including margin expansion, cash flow generation, and returning value to shareholders.
Investing in the future
Each wave of tech’s advancement, from mainframes to cloud computing, has required considerable investment as companies position themselves for growth. In recent years, the consumer internet, e-commerce, and the cloud have each gotten their turn to plow ahead into investment cycles.
Investors happily went along, tolerating high levels of customer acquisition costs and capital expenditures (capex) with the expectation of outsized returns over the longer term. This trend received a boost during the pandemic as companies were enticed by low interest rates and a dramatic pull-forward in demand. But while these outlays were often justified as much of the global economy adapted to working and shopping from home, many assumptions about future growth proved off the mark. Last year’s sell-off was a signal from the market that tech companies must become better stewards of investor capital.
Time to grow up
Many of today’s tech and internet goliaths began as scrappy start-ups seeking to tap large markets and, in many cases, create entirely new industries. At that stage of development, companies were able to invest through the economic cycle as any near-term macro headwinds would be more than compensated for by increased levels of penetration.
Alphabet, for example, was able to invest heavily in the aftermath of the Global Financial Crisis as investors understood the massive opportunity of targeted digital advertising. Similarly, despite a historic recession, semiconductor capital equipment companies, recognizing the fundamental role microchips would play in the digitization of the global economy, launched major research and capex initiatives.
For many companies – and for investors that understood the magnitude of the opportunity – this strategy paid off over the next decade. But adoption and expansion often lead to a level of mature growth. Digital advertising has become the market, and in doing so is more susceptible to the ebbs and flows of the broader economy.
The same holds true for e-commerce. Throughout its history, Amazon has been able to invest heavily – even through downturns – with the aim of taking online shopping mainstream. Yet given the extent to which e-commerce’s share of overall consumption rose during the pandemic, executives and investors no longer have the luxury of ignoring cyclical headwinds. Amazon’s recent headcount reductions and other steps to “right size” are testament to that.
Rules for a new era
As the ability of certain tech industries to invest aggressively through the cycle diminishes, managers must calibrate the magnitude of their investment programs to align with maturing markets. They must also prioritize optimizing operations.
The upshot is that even growth companies must now demonstrate their ability to increase profitability. Recognizing the evolution within the tech marketplace, investors will increasingly expect management teams to deliver on standard measures of financial performance, including margins, return on invested capital, and cash-flow generation. The semiconductor industry is a positive case study for managing mature cyclical growth.
This is not to say that investing for the long term is no longer important. Rather, based on specific industry dynamics, companies will have to balance investment for future growth with near-term profitability.
Investment cycles are inevitable in the tech space as companies must constantly innovate to maintain or expand market share. As end markets mature and investors demand a greater degree of financial discipline, managers must prove that they are effective allocators of capital. Going forward, we believe judicious capital allocation, a dominant market position, and the ability to generate a pace of earnings growth that exceeds the broader market will be pivotal factors in determining which tech stocks deliver outperformance.
A learning curve
As seen in a series of headcount reductions, some tech companies are already getting the message. Meta, for example, is calling 2023 its “year of efficiency” after investors fled the stock in 2022 due to what they perceived as overexpansion. Other heretofore high-growth stocks are mandating that line managers address progress on key performance indicators for the first time.
As stated, how companies approach balancing investment and profitability depends on their specific industry. Mature companies with high fixed costs and long investment cycles cannot turn on a dime to adapt to a slowing economy. Managers in these businesses must be especially astute to ensure they don’t get caught wrongfooted. For example, while we believe the growth opportunity for Software as a Service (SaaS) is substantial, these companies are already feeling the tension between balancing profitability and growth. SaaS, however, may prove nimbler during slowdowns given how much of its expense base is comprised of headcount.
From an investor’s perspective, we consider this maturation process a welcome development. Given its ability to drive productivity, we believe the tech sector will increase its share of aggregate corporate earnings over the next decade. This implies continued growth, and thus investment. However, given some industries’ maturing growth and increased exposure to the economic cycle, investors will expect profitability – and returning value to shareholders – to be newfound priorities for managers. In a positive sign, this is already occurring as many mega-cap tech companies are using their cash stockpiles to pay dividends and repurchase shares.
