Denny Fish, portfolio manager in the Denver-based Global Technology Team, discusses the ramifications of the US tax reforms introduced in early 2018 on the tech sector, and why an active approach to tech investing is warranted.
• We expect US tax reform and the rollback of net neutrality regulations to create both winners and losers in the tech sector.
• Repatriation of foreign earnings may spur sector consolidation and the return of capital to shareholders, while domestic tech firms should benefit from lower tax rates.
• Additional changes in regulatory and tax regimes are likely, especially in Europe; we therefore believe an active approach to the tech sector is prudent at this time.
Two recent developments that have garnered significant headlines – and significant conjecture – directly involve the technology sector. Rather than jumping to broad conclusions, we believe that neither US tax reform nor the rollback of “net neutrality” will be altogether positive or negative for the sector. Rather, for a majority of the sector’s market cap, we expect the new tax system will be a net zero, with some segments winning and others potentially losing.
Chance to repatriate earnings comes with cost of potentially higher effective tax rates
Given its global earnings base and the large cash balances held offshore by the sector’s giants, tech – perhaps more than any other sector – will be acutely affected by the change in US tax policy. Many companies will benefit by bringing cash back to the US from overseas, but they might face higher tax rates at home and abroad I the longer term. Smaller companies that tend to be domestically-focused will benefit from lower tax rates while incentives on capital spending could help the semiconductor and hardware sectors. Increased levels of available cash could cause a rise in the merger and acquisition (M&A) market for smaller technology companies.
The global earnings base of mega-cap tech companies implies that their effective tax rates might see a slight bump. For companies in the midst of a growth-inducing investment cycle, the reality is that they don’t have earnings, so the shift in tax methodology should have little effect. One hidden positive is the change in expensing capital expenditure. This shift, along with any boost to economic growth the tax package provides, may incentivise corporate users of technology to increase investment budgets.
Technology expenditure has changed over the years as services command a greater share of spending compared to hardware. A tax-induced bump, therefore, may not be as pronounced as in the past. However, we should expect some benefit, as roughly 80% of enterprise technology spending is allocated to on-premises products as opposed to the cloud.
The $2.5 trillion question: invest domestically, abroad or return capital to shareholders?
The ability of multinationals to repatriate foreign earnings on more favorable terms may also prove beneficial. We expect some dollars will be returned to shareholders, while others may fuel a wave of consolidation. For the same reasons we favour smaller-cap innovators, large-cap incumbents may consider them attractive acquisition targets.
Net neutrality rollback may further strengthen internet behemoths
Similarly, the rollback of net neutrality should produce both winners and losers. We believe large-cap internet companies will benefit as the change in regulations makes it more difficult for upstarts to gain a foothold. This reflects our view that much of the future growth in online applications will flow to internet giants as their scale has reached a point that their data-collection abilities and ecosystems provide highly defensible competitive moats. However, internet service providers may also be able to charge large internet companies for access to their customers.
As evidenced by these policy changes, we constantly survey the market to determine where regulatory and policy risks may arise. We continue to believe Europe is more likely to increase oversight of the sector than the US. In addition to privacy concerns, corporate structures aimed at minimising tax liabilities may come under scrutiny. Already, some companies are shifting some of their tax base away from historically tax-friendly countries as a potential olive branch to regulators.
Dynamic policy landscape further justifies an active approach to tech investments
We expect to gain greater clarity as to how tech companies navigate tax system and regulatory developments during earnings calls over the next several quarters. While employee bonuses and promises to invest domestically garner headlines, it will take time to draw conclusions on the long-term ramifications of these policy shifts. The varying degrees of how sector players will be impacted based on their geographic reach and other factors are the types of considerations that active managers tend to more effectively capitalise upon compared to passive strategies. That, coupled with our belief that passive strategies tend to favor the winners of yesterday at the expense of the innovators of tomorrow, lends credence to our view that active management is best suited for navigating the ever-changing tech landscape.