Tech market sell-off: the bigger picture

27/11/2018

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In this article, Alison Porter, Richard Clode and Graeme Clark, portfolio managers in the Janus Henderson Global Technology Team, explain what has driven the recent correction in the technology market and how this recent volatility affects the team’s positioning going forward.

 
What has happened?
Over the past six weeks, volatility has hampered markets and global equities have suffered a coordinated sell-off that offered little respite and few places to hide. While the pain has been widespread — with the likes of industrials and biotech taking large losses — the global technology sector also corrected sharply, down more than 9% in October1. Year to date, however, the technology sector has outperformed the broader market despite recent weakness2.
 
What caused it? 
The recent sell-off was the culmination of a combination of factors. While US corporation tax cuts and personal tax reduction helped to boost growth and reflate the US economy, the recent rise in 10-year Treasury bond yields has resulted in worries over stagflation. With ongoing concern over tariffs, investors have become concerned about rising costs and, importantly, slowing growth and a policy mistake.
 
Technology, given its strategic national importance, has become a key pawn in the trade war between the US and China, with restrictions placed on M&A and exports to strategic suppliers. After three fantastic years, the semiconductor sector also began an inventory correction, spurred by slowing capital expenditure in data centres and a slower-than-expected ramp in new iPhone production. These concerns have manifested themselves in a weaker near-term outlook for earnings, particularly in the more cyclical parts of technology such as semiconductors. There has also been concern over valuation on the higher growth, longer duration stocks within the sector, where even companies reporting strong results have sold off.
 
The bigger picture
It is important to note the context for this. It is not the first time we have seen this corrective action over the past 10 years. Indeed, there have been more than seven instances of technology sector sell-offs being greater than 10% in that time3. This sell-off has occurred after a very strong performance run from late 2016 to 20182.
 
The technology sector is now much more diverse than in the past in terms of end-market drivers and valuations. We have noted with clients in recent months the considerable divergence between the most and least expensive technology stocks. Flows of capital into narrow thematics and privately held names had resulted in overvaluation “hype” in some select areas within the technology sector – areas such as robotics and cryptocurrency. It has always been a hallmark of our investment style that we aim to navigate these areas of hype and focus on the opportunities with more attractive valuations.
 
Valuation and earnings growth
Overall, following year-to-date sector outperformance and recent weakness, we regard valuations as being neutral but becoming more attractive again, with the sector trading at under 16 times forward 12-month earnings3; a 20% premium to the broader market4 and in line with its historical average4. This is in stark contrast to the internet bubble (late 1990s/early 2000s), when the technology sector traded at more than twice that of the broader market5; at 63 times forward earnings5. We continue to believe that technology’s modest premium to the broader market is warranted given its balance sheet strength (indeed it is the only sector with a positive net cash balance), lack of pension liabilities and superior earnings growth.
 
Having said this, we acknowledge that the second half of 2018 and into early 2019, the technology sector is likely to see slower earnings growth versus the broader market and potentially negative earnings revisions. We believe cautious earnings guidance reflects the headwinds mentioned previously and the fact that the sector will get less benefit from the US corporate tax reduction than the more (US) domestically-orientated sectors. We expect the structurally superior earnings growth of the sector to once again be evident as we progress through 2019.

Outlook
While the macro drivers of the sell-off are unlikely to dissipate in the short term, we remain constructively biased on the long-term outlook for technology equities. The long-term secular drivers for the technology sector remain intact and should not be impacted materially by the global macroeconomic outlook.
 
We continue to believe that technology will take share from the wider market, driven by demographics and Moore’s Law*. As was the case in 2015-16, following 2013-14 strength, we believe the sector is going through a natural digestion of gains with temporal slowdown in relative earnings growth and momentum. In the past, we have highlighted the bifurcation of valuations within technology and even between the FAANG* names such as Netflix versus a Google or Apple, for example.
 
There remains a rich vein of technology stocks that we can buy in the middle ground that provide attractive risk/reward and growth/valuation combinations. We also continue to see evidence of ongoing digital transformation in payments, as well as a move of corporate IT budgets towards next generation infrastructure, public and hybrid cloud, and increasingly, in spending on 5G networks.
 
We remain focused on quality companies, which benefit from powerful secular themes at a reasonable price, and believe our highly differentiated investment style equips our strategy well for these sorts of markets. Valuation discipline, risk awareness and – notably – liquidity awareness help us to manage both the risks and opportunities that volatility offers.
 
Performance and positioning
Despite the outperformance of high growth, high valuation stocks in some of the more hyped parts of the market earlier in the year, our strategy has kept pace year to date with its peers on average6, benefiting from our valuation-disciplined style and what we believe is an attractive overall price to earnings ratio relative to many of our technology peers.
 
Throughout the first nine months of the year, we have maintained our valuation discipline and have been reducing exposure to some of the higher growth stocks on higher valuations. While our focus is on bottom-up fundamental analysis, earlier this year we did reduce our emerging market exposure due to a combination of the slowdown in China and excessive valuations in many stocks. The strategy also moved to an underweight position in semiconductor companies earlier this summer, with zero exposure to analogue semis, which are now entering a down cycle, and significantly reduced exposure to commodity stocks. In some of these areas where we have reduced exposure, post the October sell-off, some more interesting valuation opportunities are emerging and we are cautiously identifying some entry points on best of breed names that we believe will provide attractive long-term returns for clients. 
 

*Glossary:
Moore’s Law: predicts that the number of transistors that can fit onto a chip (integrated circuit) will roughly double every two years, therefore decreasing the relative cost.
FAANG: an acronym for five of the most popular tech stocks in the market: Facebook, Apple, Amazon, Netflix and Alphabet’s Google.
 
Sources:
1Thomson Reuters Datastream, MSCI AC World Information Technology Sector, as at 31 October 2018, in USD terms.
2Bloomberg, MSCI AC World Information Technology Sector, as at 21 November 2018
3Bloomberg, MSCI AC World Information Technology Sector, as at 22 November 2018
4Bernstein, MSCI AC World Technology Sector, price-to-forward earnings relative to MSCI AC World Index, as at 20 November 2018
5Bloomberg, MSCI AC World Index and MSCI AC World Index Information Technology Sector, as at 21 November
6Morningstar as at 31 October, Janus Henderson Global Technology Fund, I share class, GBP; Janus Henderson Horizon Global Technology Fund, A2 share class, USD.
 
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