01 Mar 2023
Growth is more scarce in an economic slowdown. Now is not the time to shy away from the sector that has the longest growth trajectory, argues global technology equities portfolio manager, Richard Clode.
Key takeaways:
In hindsight 2020 was a generational anomaly, combining an unprecedented global pandemic with central bank helicopter money to repair the economic damage inflicted by global lockdowns. The subsequent two years were a painful reminder to investors that extrapolating pandemic growth rates and assuming almost 600 unprofitable technology companies in the US would all become the very profitable technology leaders of tomorrow was unrealistic. Echoes of the 2000 dot.com bubble and crash were evident in drawdowns that exceeded 70% for some unprofitable cloud software, e-commerce and fintech stocks, among others1, and the significant declines experienced by the highest-valuation tech companies that performed so well in 2020.
The catalyst for that pain was a major resetting of interest rates expectations as inflation surged. However, with the US Federal Reserve (Fed) belatedly aggressively hiking rates and with the economy already slowing, we believe peak rate expectations have passed and therefore peak discounts for valuations for growth technology companies too. Much of the valuation derating to deflate the excess gains in the tech sector in 2020, as a result of the pandemic accelerating technology adoption, now appears done.
Even if the Fed is successful in taming inflation, rates will not be returning to zero and central banks will need to continue to taper bloated balance sheets (central bank inflated their assets as a result of bond-buying to stimulate the economy) built up through the Global Financial Crisis and pandemic. The bull market from 2009-22 was defined by zero interest rates and quantitative easing (QE); the next bull cycle will be very different. Companies are being forced to be self-sufficient in terms of funding and capital raising, driving a focus on profitability and positive free cashflow.
"The days of funding growth “via the next cheque from Softbank” are over. This ‘new normal’ has exposed the poor quality of the growth of many pandemic beneficiaries (see Figure 1) that are now in a ‘de-growth’ phase (shrinking). Identifying true growth companies in a slowing global economy will require skill and in-depth company analysis, instead of just buying the latest thematic exchange-traded fund (ETF)."
True growth companies will need to have a competitive moat and the right business model to make money. It took around 20 years for unprofitable technology stocks to come back in vogue post the dot-com bubble; unless there is a return to global lockdowns and ‘free’ money it is unlikely those type of technology stocks will define the next bull cycle.
Figure 1: A third of tech companies were unprofitable
Source: Janus Henderson Investors, Bernstein, as at 4 January 2023. Unprofitable technology stocks= (# unprofitable technology stocks/total number of tech stocks within largest 1500 US stocks).
FAANG was an acronym for the five best-performing US tech stocks, which came to define the growth of the technology sector in the last bull cycle. That was a function of being key beneficiaries of the mobile cloud era and their commanding franchises, allowing then to outgrow the rest of the stock market. Looking forward, given their size, the saturation of some of their markets and regulatory headwinds, it is unrealistic to expect these tech giants to demonstrate a similar growth premium in the next bull cycle. New technology trends will emerge, as will new leaders that are capable of delivering outsized growth. And the stock market will reward them, coining new marketing acronyms. Similar to a decade ago when the technology index was loaded with PC and storage companies, this new cycle is likely to present significant opportunities for bottom-up stock pickers and active investors who can identify those future leaders.
Long-term technology trends continue to be strong because they are addressing a multitude of global challenges. Whether to meet climate change targets, a declining Chinese workforce, shortage of skilled labour or the inflationary costs of raw materials, all companies are seeking efficiency and to do more with less. Technology continues to be the solution, offering faster, better and cheaper products, driven by Moore’s Law, to a growing digital native demographic that is more willing to adopt new technologies.
ChatGPT is just the latest example of technology’s ability to boost productivity and is a watershed moment for generative, content creation AI. While still limited in its true intelligence, ChatGPT has democratised AI. After reaching 100 million users in only two months since its launch, the chatbot is driving a period of rapid innovation, bringing AI co-pilots to numerous software applications. Coding, education, legal, marketing and journalism are just some of the industries that could benefit from the productivity gains generative AI can provide.
In the assessment of new technologies, it is important to navigate the hype cycle by focusing on realistic expectations of growth and profit, not just revenue growth. We believe the trajectory of earnings estimates is the primary driver of stock returns. The pandemic led to unrealistic expectations for growth, which proved unsustainable. The broader stock market, including the technology sector, now needs to factor in a slowing economy, with the only real debate being a soft or hard landing.
Corporate earnings expectations remained stubbornly high through 2022 for most technology companies, except some cyclical, more economically-sensitive areas, but by later in the year we started to see the first, broader earnings estimates cuts, a process that has continued into early 2023. This has brought earnings expectations down to more reasonable levels. We believe the sector is close to completing that revision process (see figure 2). Recently, we saw Intel’s 4Q profit fall by the most in two decades, Samsung’s memory business profits falling 90% in the fourth quarter and Amazon Web Services reporting much weaker-than-expected revenue growth in January 2023. These are just some examples of the major resets we have factored in for the sector.
Figure 2: Tech earnings revisions – closer to a bottom than a top
Source: Morgan Stanley, Bloomberg, as at 14 November 2022. Number of technology companies with positive or negative earnings revisions.
A combination of more reasonable earnings expectations and rational valuations make us more optimistic on the outlook for the technology sector, in addition to the long-term technology trends that remain intact. The experience of 2022 was painful but ultimately cathartic for active stock pickers who focus on fundamentals such as profits and cashflow. Bear markets historically have not tended to last for that long and entering 2023 we were already over a year into that bear market. The next bull market cycle will come and could even have already started. Historically, the technology sector has outperformed other sectors in 20 of the prior 23 bull cycles since the 1930s, making this far from just a recent phenomenon2. However, this new bull cycle when it comes, will likely reward profitable technology companies and the passing of the baton from the FAANG stocks to new leaders.
1From late 2021 to early March 2022. Cnbc.com: Here are the 10 of the worst-performing tech stocks from recent washout.
2Oppenheimer & Co., Bloomberg. Past performance does not predict future returns.
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