Recent volatility in the tech sector may cause some investors to lose sight of the powerful forces that have propelled tech’s earnings growth; yet Portfolio Manager Denny Fish argues that a long view is essential for maximizing the opportunity presented by the transition to a digital global economy.
- While many investors have pointed at recent volatility to call for sector rotation or a shift to value stocks, we believe some of the most promising secular growth opportunities remain in tech and Internet-focused communications stocks.
- We sit on the cusp of the Fourth Industrial Revolution where a greater share of economic profits are likely to shift toward digital rents as artificial intelligence, the cloud and increased connectivity improve efficiencies across the entire economy.
- The later stages of this summer’s tech rally showed evidence of indiscriminate buying, with little differentiation between companies leveraged to secular themes and purely speculative stocks and legacy companies facing significant headwinds.
Tech stocks just can’t keep out of the spotlight: first by outpacing broader equities over much of the past couple of years, then with a swift early September sell-off. The relentless upward march in technology prices and valuations we have witnessed has brought many a prognostication on why we need to see a sector rotation or witness a “regime change" from growth to value.
To be clear, that may very well happen, and we respect the potential. We are not numb to the power of shorter-term market movements, particularly when at what can be perceived as near-term extremes. But we believe we are on the cusp of the Fourth Industrial Revolution as economic profits get redistributed to digital rents and away from many legacy industries. Importantly, while many technology stocks have seen significant price appreciation, many of the market-leading tech and Internet-focused communications companies offer some of the soundest fundamentals and best secular growth across all equity sectors, which has led to strong financial performance. We continue to believe this bifurcation could continue over a multi-year basis.
It’s an inexact science to identify a specific catalyst for a sell-off, but in the case of tech’s recent downturn, there are plenty of candidates. Foremost, tech has led markets for much of the past couple of years. But as explained below, this is not without some justification. Given the gains – and indeed recent record highs on equity indices – periodic profit-taking can play a role. For investors with a shorter time horizon, such a step may have been considered prudent given a range of risks including the upcoming U.S. election, the COVID-19 pandemic and shaky global growth prospects.
Rooted in Fundamentals
Our view, however, is that tech investors are better served by maintaining a long-term horizon given the compounding effects of truly special businesses. Tech’s solid fundamentals have been building for several years with many companies seeing outsized rewards in the public markets in 2020. Returns ebb and flow but we believe growth stocks are among the longest-duration assets that tend to find ways to stay the course with the best business models. This is especially true for the tech companies leveraged to the secular themes of artificial intelligence (AI), cloud computing and the Internet of Things (IoT). These complementary forces are the underpinnings of a digital global economy that has been years in the making.
As tech and Internet stock prices rose over much of this year, they commanded a higher portion of the growth equities universe. While growth indices’ tilt toward tech raised some eyebrows, mega-cap companies’ contribution to index earnings and cash flow growth, in many cases, has even exceeded the pace at which their share of several benchmarks has risen.
The Power of the Fourth Industrial Revolution
This year’s powerful run by tech stocks has drawn unflattering comparisons to the dot-com bubble of 20 years ago. There is a major difference, however: In contrast to that era, today’s tech stocks are delivering on the promise of bringing efficiencies to companies and value to consumers.
Many of these benefits are being powered by the technologies that we consider the building blocks of the Fourth Industrial Revolution. Similar to the role played by steam and semiconductors during previous waves of innovation, data is the catalyst for this period. Information collected through IoT-enabled devices or user information on the Internet is processed in the cloud – often through AI-driven algorithms – and used to make more informed business decisions. While these elements have been in place for a while, they were acutely called into action during this year’s economic slowdown as companies scrambled to maintain access to customers and ensure their back-office operations optimally functioned.
Investors are coming to appreciate the virtues of network and platform effects associated with large tech platforms driving these secular themes, hence the fairly broad-based lift in markets. Importantly, though, tech is not homogenous with predictable distributions of winners and losers. The later stages of the recent tech rally have shown evidence of indiscriminate buying, with little differentiation made between stocks leveraged to long-term drivers and those that are more speculative or actually have negative transformational headwinds. Times like these are where active management may be of benefit.
Despite the leading role played by tech in transforming the global economy, appropriate due diligence remains an essential part of the investment process. Several swaths of the sector may need to be avoided, either by their legacy nature or – for more speculative companies – little visible path to widening competitive advantage and normalized profitability. Instead, an investor’s focus should remain on identifying capable management teams, identifying the best underlying unit economics and – with an eye toward future growth – exploring business adjacencies complementary to a company’s core offering that the broader investment community may not yet appreciate.
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