Global Perspectives: Redefining growth potential in the technology sector
Portfolio Manager Denny Fish discusses the implications of higher rates and a potential recession on the tech sector and how he sees mega-themes such as artificial intelligence (AI) and cloud computing evolving in the years ahead.
23 minute listen
- With their connection to powerful secular tailwinds such as cloud computing and AI, many fundamentally sound tech companies appear poised to emerge from an economic downturn even stronger.
- The transformative potential of the cloud and AI has broad implications for businesses, society, and geopolitics. It will be critical to understand which companies stand to benefit from these themes and which will end up on the wrong side of disruption.
- In our view, a fundamental, active approach to picking winners and losers can help avoid value traps in the bifurcated tech market, particularly in a tougher economic environment.
Alternatively, watch a video recording of the podcast:
Lara Castleton: Hello and thank you for joining this episode of Global Perspectives, a podcast created to share insights from our investment professionals and the implications that they have for investors. I’m your host for the day, Lara Castleton, U.S. Head of Portfolio Construction and Strategy at Janus Henderson.
And this year during my client consultations, one of the hottest topics has been technology. Not only are we so personally tied to the sector – case in point this audio podcast that we’re also shooting as a video to be streamed online to your phones and via social media – but it has created quite the rollercoaster ride for investors over the last 18 months. The three biggest questions that I get in terms of technology is, one, the macro environment, higher interest rates, potential recession – what is going to be the impact to technology? Two, is this massive market concentration going to continue indefinitely? And then three, just where to start with artificial intelligence, or AI?
So, to scratch the surface on those three, I am thrilled to be joined by Denny Fish, Portfolio Manager on the Janus Henderson Global Technology and Innovation team. Bay Area resident and 20-year veteran. Denny, thank you for being here.
To get started, I think we need to talk about the macro environment a little bit. 2022 was not a good year for technology companies, as most of them had to reprice valuations as rates rapidly rose. 2023 was maybe looking to continue that trend, but then banking crisis, ChatGPT, a lot of that did seem to buoy some technology valuations again. Starting today, where we’re at, what do you think about in terms of rates, assuming that we are nearing the end of hiking cycle, and the implications that higher rates do have for technology?
Denny Fish: That was a good framing of what’s happened. Because it really has been an interesting dynamic. As we think about rates, as you mentioned, if we think about the year 2022 and the rapid increase that we had, the market just took on a life of its own, and that was we’re just going to re-rate valuations down lower for anything that has a growth element to it. It was pretty indiscriminatory, and so we had to deal with that as we got through.
As we got to this year and the pace of the increases started to slow, the market started to revert back to fundamentals. And in many cases, a lot of technology companies have continued to have strong fundamentals, or the perception of what the fundamentals are likely to be on a go-forward basis, are actually pretty strong over a multi-year basis.
And so, I feel like now we’re in this environment where it’s equally as important to understand where rates are going as it is to get the “G”, the growth number, right in terms of what the growth and revenue is going to be, what the growth of margins is going to be, and how that’s going to translate down to earnings growth. For the most part, tech is in pretty good shape, and we’ll talk more about the different areas of technology, but the companies have shown resilience so far in terms of the business models.
Even semiconductors are in a tough part of the cycle, but investors are recognizing the importance of semis over the longer term. Therefore, the way that they’re discounting those earnings aren’t nearly as severe as they have historically. Just think about what happened during the pandemic. During the pandemic, you couldn’t get a washing machine, you couldn’t get a car, you couldn’t get anything because there were no semiconductors available.
Now we’re going to have this global buildout over a long time and investors [are] more comfortable with the cyclicality of that because of the importance to the sector. So, even in areas where the earnings growth hasn’t been that strong, the terminal values have actually gone up for some of these assets, too.
Now bring that all forward, what happens in 2024? It feels like we’re going to have a softer economic environment. The pace of rates should moderate a lot, but the reason they’re going to moderate a lot, likely, is because we’re going to get that softer economic environment that the Fed wants.
And so, generally speaking, what happens in those environments is that growth companies with resilient earnings tend to actually perform pretty well, so it becomes a much more selective market. Companies that are benefiting from secular trends are likely to get higher multiples, and the companies that actually show the earnings growth are also likely to sustain their multiples. It’s this continuation, like what’s happened this year, where even though there’s concentration at the top of the indices in terms of what’s performed well, under that we’ve also seen a lot of bifurcation, which has really created more of a stock picker’s market than one might perceive on the surface.
Castleton: 2022 was maybe a little bit of a blanket reaction because it was quite a jarring year to see. We haven’t seen a rate-hiking cycle of that scale really in modern times, so blanket reaction, 2023 back to fundamentals, and that should be what we look for going forward. 2022 in client portfolios saw a lot of people just underweight technology, so the biggest question for them now is, as we are 18 months in, again the most anticipated recession ever, I don’t know if I want to get back into technology yet.
You mentioned this a little bit already, base case may be more soft landing next year. If a recession were to hit, however, what do you envision the impact would be to technology? I’m assuming it’s not just, again, this blanket reaction like 2022; there will be winners and losers.
Fish: Yes, there will be winners and losers, the way that in a soft-landing environment the secular growers are going to continue to be secular growers because they have powerful trends behind them. So, you’ve really got to bifurcate what’s just truly macro sensitive and how are those companies going to be impacted. Typically, those are slower growth companies, typically those are companies that maybe don’t have the same secular tailwinds of cloud or AI that a lot of technology companies have. And so, that should be helpful as we get through it, but once again, it’s going to be a bifurcation.
In terms of tougher macro environments, [they] generally do a couple of things. They make the strong stronger. They force companies that haven’t been operating as efficiently as they should to operate more efficiently, build more operational muscle, come out stronger on the other side. And then there are companies that already had secular challenges, that maybe … and this is where investors need to be careful. Companies with low valuations performed really well in ’22; some have performed well in ‘23. Those business models really get tested when the macro environment gets a lot tougher, so you can end up with a lot of value traps, particularly as you go into a tougher macroeconomic environment.
Castleton: Interest rates, higher than they had been. Potential economic environment that’s slowing, that is very much conducive to having a fundamental approach and potentially a different environment going forward with active managers picking the right winners over the last decade. That gets us to market concentration, because we have seen over the last 10-plus years seven names drive the index, broadly. I think the biggest question on everyone’s minds is, this year, those companies that seemed to be the defensive trade, is that going to continue going forward?
Fish: It’s an interesting question because what’s happened over that period is, if you just look at the aggregate cash flow that these companies have produced, it’s staggering. They’ve grown multiples of GDP, they’ve grown multiples of the market, the returns on capital are higher than the market. For all the right reasons, these companies have become bigger and bigger components in the indices.
And with secular tailwinds associated with them, it just seems to me that these companies can continue to deliver and then the question is, what multiple do you put on the stocks? Those are the things that we have to figure out. But there’s a reason that they’ve grown so concentrated.
And then as we think about that layer underneath, it’s important because that’s where we’ve seen a lot more bifurcation. And where you can add a lot more value to the portfolios and to investing, as you sift through the carnage from rates that crushed everything and then you figure out the companies that are going to continue to be winners on the other side, the companies that generate this operational muscle and are much better businesses for the long term. And so, trying to find those next big names that are going to climb up in the indices over time.
Castleton: It sounds like there is good reason that these companies have grown as large as they have been. And they will and absolutely do warrant a place in portfolios going forward. But there is a lot of exciting opportunities outside of them, so maybe we can start to dig into some of those, in terms of what you’re looking for outside of the big names. What’s exciting to you?
Fish: I think a number of sectors. Semiconductors … I ask people this question sometimes, “What do you think has been a better stock over the last decade? Is it a basket of semiconductor capital equipment or Alphabet?” And most people say Alphabet. It’s actually that basket of semiconductor capital equipment companies. And the reason is because they operate as narrow monopolies, and monopolies in some cases. They’re really five major companies that dominate the space globally. And semiconductors are arguably the most important sector on the planet because without semiconductors, the economy now grinds to a halt.
And so, every major geography now – either because of geopolitical tensions between, say, the U.S. and China, or just because of what countries felt during the pandemic – want to have their own, sustainable ecosystem of semiconductors. We’re in this multi-decade shift to every major geography spinning up fabs, creating their own supply, wanting to be self-sufficient. You don’t find that many opportunities where you can look at the next decade and go, “Okay, I feel really confident in the terminal values of these companies and how they’re going to be more and more important over time.”
Similarly, the cloud continues to increase in adoption. We’re probably only 25 or 30% adopted. And it’s weird to be 10 or 15 years into a mega-theme and that theme’s still going to play out for another decade, so we’re still excited about that. And that’s the hyperscalers, it’s software as a service, it’s the enablers with semis, as well. Now we have this kicker – and we’ll get to it, with artificial intelligence – that is now the next big mega-theme that’s a handoff from what we’ve seen with cloud and mobile over the last 10 or 15 years. And artificial intelligence is only enabled because of everything we’ve done over the last 10 or 15 years.
I actually think it’s a really exciting time to be investing in technology. Every recession that we’ve gone into, if we do go into a recession or whatever it turns out to be, the strong come out stronger, the secular trends are only more pronounced on the other side. And it tends to be an incredible investment environment for finding secular growth winners. So, we continue to be really excited.
Castleton: I want to go back to the statement you mentioned earlier because I think that needs to be repeated, that over the last decade, a basket of semiconductor stocks was actually a better investment over the long term than Alphabet. Because a lot of clients, I do think they’re invested in S&P [500 Index], and they talk about the top seven names, and they just don’t think about what’s out there, underneath it. But in technology, there’s a lot of opportunity, so the risk of being passively allocated to a market-cap-weighted tech benchmark is, I would assume, just missing out on maybe some of the big drivers of growth going forward within the sector.
Fish: Yes, that’s right. You’re going to have periods during times of uncertainty where maybe two or three of those companies are going to hold up exceptionally well and they’re going to beat the index. And then you’re going to have periods where these disruptors or the innovators that you can invest in that can grow from. It’s a lot easier to grow … well, nothing’s easy, but it’s easier to grow from a $5 billion or $10 billion market cap to $50 billion than it is to go from $2 trillion to $10 trillion.
And so, those are the things that we get excited about, to augment these really great companies that in many cases you could argue are the new consumer staples in terms of the way they’re acting in the market and the consistent financial performance that they’re putting up.
Castleton: Very interesting. That does lead us then to AI. Talking about themes, cloud, semiconductors, you have been talking about AI for a very long time as a secular theme. But it did capture the world’s attention at the start of 2023. I think helpful to just maybe address why that was. And then, again, you’ve been talking about this for a while, so what’s your thoughts on AI as a secular theme?
Fish: Yes, we have been, and I remind people that a lot. It’s been on our slide deck for five years as a mega-theme. But it was also in the context of very discreet applications of AI. Think about Gmail and how when you go in to type an email and then it starts realizing what you’re going to type, and it helps you to type that out. That’s called predictive text or personalization in the consumer internet space.
AI and machine learning was really used for these discreet functions. The big ah-ha moment in November of 2022 was the release of ChatGPT 3. We’ve been following ChatGPT for years, just in terms of how it had been evolving, but ChatGPT 3 was huge for a couple of reasons.
One, it did what I call crossing the chasm. We went from AI to broad-based generative AI. Where now you weren’t attacking a discreet problem with AI, but you were taking a large language model – there are a number of them that’ve been developed over many years – applying as much of the world’s public data as possible and creating an engine that could pretty much generate whatever you need generated. PowerPoint presentation, customer service scripts … there’s just so much we could go through. It was that moment where people were like, wow, now we’ve changed forever. Because regardless of how this technology evolves over the next year or two years, the 10- to 15-year journey is firmly intact.
There’s an old saying in technology, we always overestimate what’s going to happen in a year and then we completely underestimate what’s going to happen in a decade. And we’re at that point with AI now and it’s because we took that step towards generative. And that was only possible because, infinite access to compute, because of cloud computing. The amount of data that could actually be captured and prepped and stored in a way that was sufficient for large language models. And then the large language models to actually be at the scale needed to process that information. And it took all three of those conditions coming together to be able to put something into the market that turned out to be the fastest-growing consumer application ever in the history of the planet, and that was ChatGPT. Zero to 100 million users in the snap of a finger.
Castleton: Personally, I love that I don’t have to come up with a bedtime story for my kids anymore. I know there are a lot more sophisticated uses for ChatGPT and it does seem like the hype has been massive this year. And your point is very well taken, that overestimating near-term but underestimating long-term implications of this type of technology. Just where do you think AI will have the greatest impact in the corporate sphere, but then broader society as well?
Fish: There are two ways. There’s technology specific, where you’re going to have the picks and axes and the enablers, because none of this gets done without a GPU, so you have that. Then you have tons of technology companies that are going to be on the wrong side of time, they’re going to really be disrupted. And then you have ones that are going to be able to leverage the existing competitive advantages that they have around data, for example. Whether that’s vertical software companies or people in the semiconductor supply chain. And those are going to be unique opportunities to actually invest as well, so that’s tech.
But the boarder corporate sphere, the potential for productivity enhancements, this has the potential to be one of the biggest productivity multipliers that we’ve seen in generations. That has broad implications because you’re either on board and you’re leveraging AI to be competitive, or you’re not, meaning you’re losing competitiveness, whatever industry you’re in, whether it’s autos, airlines, ag equipment. Whatever it is, everyone’s going to have to deploy it in some sort. This has elevated so fast in terms of what the implications are.
And then security is only going to get tougher and tougher because the bad guys are going to have AI tools. They’re going to make it much more difficult, and so that’s going to put a lot of pressure on organizations. Then just broad society, we can argue we just don’t know what it’s really going to mean for certain types of jobs, but there’s a reasonable case that there are many what I call entry-level, white-collar jobs that are going to get disintermediated, just because of what generative AI can do. And those are things in law, in accounting. Just a number of industries you can look at and you can say, that’s really ripe for disruption. So, there’ll be some implications there. Clear implications in terms of geopolitical dynamics. There’s a reason why we’re cutting off access to semiconductor capital equipment. Because we need to protect that technology so we can protect ourselves as the world continues to be a more and more uncertain place.
That has broad implications, too, and so it really is going to get infused through all of corporate America, it’s going to get infused through society in general. And then that brings government regulation into play, as well. It’ll be really interesting to see how individual governments regulate AI and how collective governments try to regulate AI, to make sure we’re having the most positive impacts we can on society.
Castleton: There’s a lot of factors in play for AI and there’s just so many directions to go with it, it’s very exciting. For investors, how should they think about approaching it from an investing perspective? Is it just the big names? Do they need to have this process as their level of start with the end goal and applications for an industry? How would you address end investors as they’re thinking about AI? And maybe is there anything that they’re missing in terms of this technology?
Fish: I think a couple of things. One is, just coming to technology in general, a lot of times people are like, only investing in technology’s pretty risky. Well, actually, it’s been risky not to invest in technology. Because over the last 15 to 20 years, that’s where more economic growth has actually occurred. Tech generally grows a multiple of GDP and the businesses have higher returns, and now we have this potential super-cycle of AI that gets layered into it.
The challenge is, it’s not a rising tide lifts all boats. And we’re going to have more competitive intensity among the big seven that we talked about. We’re going to have a lot of losers and a lot of winners as we get down the market-cap range. And for what are perceived to be sleepy, safe companies, [we] need to understand what the implications of AI are, because they might not need to be so sleepy. It’s really something to think about on a case-by-case basis as you think about stocks.
Castleton: Just a very different environment than we’ve been in. I think just to close it out, the last thing, just overarching every conversation, and this is, with entire portfolios as well, within fixed income portions of portfolios, all equities, the cost of capital is no longer zero. Technology has no doubt been a beneficiary of zero interest rates for a very long time. From what you’re talking about today, the innovation isn’t going anywhere and it’s still a very attractive sector, but is there any ending thoughts that you would impart on investors as you think about technology in a world where maybe the cost of capital isn’t zero any longer?
Fish: I think the key point there, any time we value a stock, there are two things. There’s the discount rate and then there’s the growth rate. Growth can outrun the increase in the discount rates, and that’s what you need to understand as we normalize this environment from the rapid rise in rates to a more normalized environment where we’re at now. And so, it’s getting both of those right, not just one of them.
Castleton: Awesome. Thank you so much for those comments. AI is extremely attractive, there’s a ton of opportunities outside of just the top seven names of the index. It just is a different environment where maybe the winners and the way we approached investing in technology over the last decade, where honestly, for a lot of clients that we work with, they could just enjoy the beta rally in the market, that is different going forward. Fundamentals matter. Growth rates absolutely can still trounce discount rates, but it’s more of an active stock picker’s approach going forward.
Denny, I just really appreciate all of your insights in here and hope that you, as investors, found this useful. We hope you’ve enjoyed the conversation.
For more insights from Janus Henderson, you can download other episodes of our podcasts wherever you get them, or visit our website at janushenderson.com. I’ve been your host for the day, Lara Castleton. Thank you and see you next time.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
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