Technological innovation - a core investment driver

25/07/2017

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Technology’s strong performance over the past year has reignited interest in the sector. We take a look at valuations in the context of history and earnings growth and focus on the unique characteristics of the sector that make it worth considering for any investor portfolio.

 

Returns history
The chart below demonstrates the performance of technology relative to the wider equity market over the last ten years. In US dollar terms the tech index is up 143%, against a rise of 53% in the broader equity index as reflected in Figure 1. A differential of 90% seems large but Figure 2 reveals that there is justification for the outperformance.
 
Figure 1: Total returns over the last 10 years
Chart 1
Source: Thomson Reuters Datastream, 31 May 2007 to 31 May 2017, total return, USD
Past performance is not a guide to future performance.
 
By breaking down the earnings of the MSCI AC World Index into tech and non-tech constituent companies, a very clear picture emerges. Technology is generating the majority of the earnings growth in the market: technology’s earnings have risen by more than 108% in the last ten years, compared with just 7% for the non-tech sector.
 
Figure 2: Earnings growth: technology versus non-technology
Chart2

Source: Bernstein, as at 31 May 2017. Note: Based on trailing earnings, rebased to 100 at 31 May 2007.
Past performance is not a guide to future performance
 
So the differential in earnings growth with non-tech has actually widened by more than the differential in share price performance. What this means is that technology has actually got cheaper in relative terms compared with the rest of the market. In fact, we can see this in Figure 3 which plots the relative price-to-forward earnings ratio of technology against the wider world. Not only is technology cheaper than it was ten years ago it is nowhere near the levels it reached during the dot-com boom around the turn of the millennium. At 1.14, technology is trading at a 14% premium to the wider world but this seems reasonable for a sector that is heavily characterised by growth and the only sector without net debt.
 
Figure 3: Relative forward PE (technology to world)
Chart 3
Source: Bernstein, as at 31 May 2017 Note: Forward P/E = Price to forward earnings. MSCI AC World Technology Sector, price-to-forward earnings relative to MSCI AC World Index. May 1997 to May 2017.
 
Perspective on valuations
Taking the analysis to the corporate level is even more revealing. Many investors choose to put their money in so-called defensive consumer staples companies. The appeal is simple: people will surely keep drinking Coca-Cola and buying Gillette razors (Proctor & Gamble, P&G) regardless of wider economic changes so investors surmise that this is a safe home for their money. Yet the earnings prospects for these companies are often far beneath those of similarly valued technology companies as shown by Figure 4.
 
Figure 4: Consumer staples v technology
Chart 4
Source: Bloomberg Consensus Estimates, 14 June 2017. Forecasts are estimates only and are not guaranteed. FY= financial year
 
In fact, technology is facilitating the disruption of many of these traditional companies. Dollar Shave Club – a business set up to sell cheap razors directly through the post to households – is disintermediating traditional retailers and undercutting established players. P&G admitted that part of its revenue miss in its most recent results was due to more intensive competition in the grooming segment, where sales were down 6%. Whether it is Amazon disrupting retailers, Purplebricks disrupting estate agents, or Google disrupting traditional advertising and media, the continual drum-beat of profits warnings from many areas of the old economy are a testament to this process.
 
Technological advantage
What is driving these share gains? In a word: innovation. At the base of all electronic technology is the integrated circuit. Since its invention in 1958 we have been able to cram more and more processing power into less space at a lower cost. This phenomenon (known as Moore’s Law after one of the founders of Intel who first predicted this trend) enables the doubling of speed, halving of cost or halving of size of a semiconductor every 18 months. New products become possible, and existing products get cheaper and better. This is why the feature phone you had ten years ago is unrecognisable from the smartphones of today. It is very difficult for other industries to compete against this trend, driving these technology share gains.
 
The biggest threat to technology is perhaps the one that faces the entire market – can equities cope if central bank liquidity is withdrawn? In this regard, technology can sometimes be a victim of its own success. In any sell-off it tends to be the first to respond, for the simple reason that investors typically sell things that have done well to bank a profit – as was the case in the most recent market reversal. However, it is our view that the long term secular trends are so strong that on a relative basis at least technology will continue to outperform other equities in the medium to long term.
 
While technology might be viewed as one sector among many by investors, it is having a transformative role in shaping the modern economy. Its capacity to generate earnings, capture market share, or facilitate that capture by non-traditional companies, is something that we view as structural and for that reason alone is worth considering for any investor portfolio.
 
 

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

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