Denny Fish is Portfolio Manager, Janus Henderson Investors, a member of The Gulf Capital Market Association.
The underwhelming performance of global technology stocks this year may have left some investors mystified as to how businesses that are supposedly the wellspring of a digitising global economy can so quickly fell out of favour.
In periods of underperformance, investors may want to revisit the industry themes and stock theses underpinning their allocation to determine whether anything has changed. We believe this question needs a qualifier: What’s changed over a three to five-year time horizon. Our answer: Very little. In fact, we believe that a slowing economy presents not only challenges that cannot be ignored, but also opportunities that can be capitalized upon by the most innovative companies.
The Irresistible Forces of Higher Rates and Inflation
For much of this year, macro drivers have buffeted tech stocks as investors assessed headwinds including inflation, rising rates and a potentially slowing economy. This has been a year of transition as the era of highly accommodative policy has come to an abrupt end. With interest rates rising, growth stocks aligned with technology-enabled, secular themes came under pressure as higher rates reduced the future value of their cash flows. Later, cyclical-growth tech stocks lost ground, held down by the possibility of a weakening economy.
Over short periods, macro (e.g., rates and inflation) and style (e.g., valuation multiples) factors can cast considerable influence on equity performance. Over a longer horizon, however, we believe that fundamentals are the ultimate determinant of investment returns. In our view, the companies most capable of delivering attractive results over these longer horizons are those leveraged to artificial intelligence (AI), the cloud, the Internet of Things (IoT) and 5G connectivity.
A Bifurcated Market – in the Least Intuitive Way
Many of the tech companies that have held up best this year are legacy names that have minimal exposure to the aforementioned secular themes. Low-growth stocks typically have low price/earnings (P/E) ratios, meaning they are less susceptible to fluctuations in interest rates. In contrast, many of the secular growers tend to command higher P/E ratios. While cognizant that any stock can get overheated, we believe many secular growers should command higher relative valuations given what we see as their unprecedented ability to account for an ever greater portion of aggregate corporate earnings growth. Yet, in periods of rising rates, these stocks can underperform due to the mechanism used to discount their cash flows.
Importantly, many of these companies continue to display solid fundamentals, something on display in recent earnings reports that have been, broadly speaking, better than feared. One of our takeaways from the current earnings season is that for many of the sector’s most resilient and innovative companies, unit economics remain strong and balance sheets healthy.
Where company performance has lagged, it has in many cases been the result of earlier successes. After their meteoric run early in the pandemic, e-commerce stocks blew off considerable steam. While it seems like the distant past, prior to 2020, online shopping was a much smaller portion of overall consumer activity, capable of gaining market share throughout the economic. Given the accelerated adoption of online shopping during lockdowns, the trajectory of the broader economy now exerts greater influence on these companies’ earnings prospects. Accordingly, signals that higher inflation is starting to impact discretionary purchases have introduced a headwind for e-commerce platforms that they’ve not had to confront in the past.
The same phenomenon has affected Internet stocks. Online advertising has risen to roughly 60% of the total ad market. As the economy slows, Internet platforms now feel the force of reduced ad budgets much more than when they were smaller players in the space.
Once the Clouds Clear
Inflation has forced the Federal Reserve to accelerate tightening to the degree that slowing growth has become a scenario that cannot be dismissed. Higher rates may keep secular-growth stocks’ valuations under pressure, and economic softness could hamper the earnings prospects of more cyclical companies. E-commerce and semiconductors appear vulnerable. Software does as well but weaker orders could be offset, to a degree, by customers seeking to leverage the cloud to increase efficiencies and defend margins.
Central to “cyclical growth” is the amplitude of a company’s operational peaks and troughs narrowing as these businesses’ products are more widely deployed. Semiconductor companies, in our view, exemplify this evolution as they benefit from an ever-increasing amount of chip content across the economy. Still, a higher cost of capital and supply chain rationalization has the potential to lower the level of increasingly chip-intensive capital expenditure. Thus far, the semiconductor complex has held up relatively well, with the exception of consumer-focused areas.
In periods of upheaval, it’s important to ask which business models will be stronger once we reach the other side.We believe it will be the secular growth companies that continue to increase productivity and convenience across the economy.
As with other sectors, the economic cycle, rates and inflation matter to tech. The combination of excess liquidity and waves of enthusiasm can push up valuations to levels not supported by fundamentals. Both tech sector management teams and investors are in the same boat when confronting these risks, meaning they should maintain focus on how technology is increasingly deployed and how that translates to delivering attractive financial results.