Portfolio Manager Denny Fish reminds investors that despite recent unevenness, the tech sector continues to deliver strong operating results and is increasingly leveraged to the secular themes associated with digitization of the global economy.
- Recent softness in certain tech stocks is likely due to some companies not exceeding lofty earnings expectations.
- While the Chinese government has altered its approach toward regulating the sector, we believe it still recognizes the power that technology has to achieve certain desired social outcomes.
- Should supply-chain shortages be resolved, we believe the sector is well positioned to benefit from both cyclical and secular growth themes over the medium term.
The past few months have proven to be a study in the crosscurrents capable of impacting the technology sector’s trajectory. On one hand, the digitization of the global economy continues, exemplified by the growth in cloud computing, the Internet of Things (IoT), artificial intelligence (AI) and 5G connectivity. These technologies, in our view, are the secular forces that will not only drive tech earnings growth in years to come, but also enable technology companies to increase their share of overall corporate earnings.
In contrast, other factors have acted as headwinds: Supply chain constraints – especially within semiconductors – limited production capacity in tech and other sectors; the Chinese government increased regulatory scrutiny of consumer-facing tech companies; the COVID Delta variant has resulted in an uneven economic reopening – a development particularly felt by global payment processors; and lastly, the specter of higher interest rates weighed on the valuations of many longer-duration growth stocks.
The confluence of these forces has resulted in one of the more complex environments for the sector in recent years. And while the near-term outlook has become less certain, investors should remember that the ascended secular themes capable of compounding earnings growth – what we call the “North Star” of tech investing – in our view, remain intact.
A Matter of Expectations
To a degree, recent softness in the sector has much to do with tech stocks being a victim of their own success as some companies were punished for not meeting high growth expectations. In many instances, investors expected recent growth rates – based on very favorable year-over-year comparisons – to become the new baseline. When those levels were not achieved, these stocks sold off despite still solid two-year, annualized growth rates – a figure we believe normalizes a company’s performance in light of these extraordinary times. Conversely, those that were able to maintain momentum by building on already impressive earnings results have been rewarded.
Another headwind for the sector relates to China’s Internet space. We’ve followed developments in the regulatory landscape for the country’s customer-facing tech companies. The range of potential outcomes has broadened in light of government policy possibly having a greater role in determining industry structure and corporate priorities. Future developments require further observation. But we believe that the central government still recognizes the power of innovative technologies to drive economic growth and achieve certain desired social outcomes.
Secular, Cyclical – or Both?
Much of the complexity facing the sector centers on which of the current sources of volatility prove transient and which are structural. We believe the semiconductor shortage should normalize as global capacity is added. The path likely won’t be smooth, and we believe near-term bottlenecks will continue to impact multiple industries. Longer term, the demand for capacity should be supportive of the technologies that enable chip production, especially as IoT is further deployed.
Much ink has been spilled on whether the recent rise in inflation is sticky or fleeting. This impacts the tech sector insofar as to how it influences interest rates. Higher rates tend to compress valuations of longer-duration assets, including secular growth stocks. Multiple compression, however, may present attractive entry points to secular growers in the sector previously deemed overpriced.
Given these crosscurrents, we anticipate additional choppiness in coming months. Longer term, we are positive on technology. Secular themes remain intact and continued economic reopening should buttress cyclical growth stocks. The market must always contend with exogenous forces, but we firmly believe that long-term tech returns will ultimately be dictated by financial performance.