20 Dec 2021
Recent interactions with investors and clients convince us that the market is attempting to gauge the durability of sector growth in this increasingly post-crisis world. Discussions with sector participants and technology buyers give us confidence that our thesis is on track. Specifically, we believe that COVID-19 accelerated the Digital Transformation (DT) opportunity, and that growth will be robust for the businesses we own for many years as businesses and their customers seek to build upon the new digital skills they acquired during the crisis.
Information technology (IT) sector companies have traded at a premium to broad equity indexes over the past 30 years and remained above that average in November 2021. We continue to believe that a premium is warranted given the strong and secular growth in the sector, the acceleration of DT and the improving quality in the sector—e.g., a growing number of companies with data moats, platform business models, growing recurring revenue sources, strong balance sheets and strong overall EBITDA (earnings before interest, taxation, depreciation and amortization) margins. Given this dynamic, we have been more careful about adding to names trading at or above our analysts’ base case scenarios.
Despite the recent volatility tied to re-opening, rising interest rates, increased inflation expectations and a quickly changing regulatory landscape in China, we believe the sector offers solid exposure to strong secular opportunities relating to DT and its supporting sub-themes, as shown in Exhibit 1.
Exhibit 1: The key pillars of digital transformation
For illustrative purposes only.
The IT sector has outperformed the broader market in 2021, along with communication services (to a lesser extent). The general resilience of these sectors, we believe, has been driven by investors appreciating that technology was the antidote to many of the operational challenges that the pandemic created. Specifically, the pandemic helped to accelerate investment in “work from home,” cyber security, workflow automation and coordination, remote healthcare, and omni-channel commerce technologies. That said, we do not believe that investors fully appreciate what is coming next as the extended pandemic taught businesses, employees, customers, patients and students that they could be more productive and have more balanced lives using the new digital skills they built during the crisis.
Aside from valuations, risks we are monitoring include the pandemic, regulation, supply chain constraints (semiconductors, electronics manufacturing, and logistics in particular) and the implications of a growing talent crunch across IT and communication services industries. In particular, we are paying close attention to the US and EU investigations into the business practices of key digital leaders including Alphabet, Amazon, Facebook (now called Meta Platforms) and Apple. Finally, tech sales and engineering employment capacity are getting tight; as talent becomes increasingly harder to find, it may lead to more companies embracing low-code and software engineer productivity tools, product-led growth, and digital selling techniques, many of which were heavily embraced during COVID-19.
Given the dynamics mentioned above, we do not anticipate that the world will return to the pre-pandemic norms. Instead, we expect businesses to operationalize and scale what worked during the crisis, abandon what did not, and continue to iterate. We expect consumers to continue to embrace new commerce tools and to increasingly prefer digitally augmented experiences. Simply put, we believe that the crisis was the beginning of our society’s digital transformation—not the beginning, middle and end of it. If this proves true, we believe the fundamental growth we saw during the crisis for a subset of companies and themes will broaden and extend as the world re-opens. Our discussions with many of the companies we follow indicate to us that this is exactly what is happening.
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Investments entail risks, the value of investments can go down as well as up and investors should be aware they might not get back the full value invested.