With contributions from
Tom Aust, Vice President and Senior Research Analyst
Frederick Grieb, Vice President and Senior Equity Research Analyst
Following the revelations about data breaches at tech giant Facebook, which wiped $37bn off its market value in one day, have we reached a turning point for the technology sector in terms of valuations? Certainly, technology has become so critical to the global economy that it has attracted attention from regulators around the world. Greater scrutiny has therefore been a risk for some time, though perhaps not fully priced in, meaning there may be further short-term headwinds for the biggest players. Governments such as the US and China are also taking an interest in technology champions that could be pivotal to future trading relationships.
Regulatory and geopolitical risks aside, however, fundamentals for the technology sector remain attractive. It continues to be a major driver of innovation and growth, while displaying some defensive characteristics as the sector matures, and should benefit from the global economic recovery. Investors still need to be careful with their stock selection, as technology is bifurcating ever more sharply into winners and losers, increasing the potential for value traps. Longer term, previously robust growth rates may be hard to replicate over the next decade without expanding into new revenue areas and altering the risk/reward dynamics.
To address these complex sector-specific risks, our quantitative analysts are exploring new ways of measuring the value of intangible assets such as software, in an attempt to reveal stock pricing anomalies and highlight where company valuations are stretched.
Constructive on Technology Stocks This Year
Despite Facebook’s recent woes, technology valuations are still often perceived as rich relative to other sectors. But this perception fails to account for the diversity of businesses within the sub-sectors and the long-term growth potential of companies that are leaders in their fields. Even after an exceptionally strong run in 2017 and the possible impact of greater regulatory intervention, the shorter-term outlook for technology remains robust. In our quantitative analysis, where we assess the attractiveness of each sector versus the others, the tech sector’s value metrics continue to score highly. Momentum and sentiment are also favorable, with sentiment capturing the recently strong upward earnings and revenue revisions exhibited by the sector.
The tech heavyweights — Facebook, Apple, Google and Microsoft — account for close to half the entire sector by capitalization, but contributed the most to the sector’s 47% share price rise in 2017. Even after the sell-off in Facebook shares, the IT sector continues to be the strongest performing sector year-to-date. Outside the US, we have seen further growth in Chinese behemoths such as Alibaba and Tencent — the latter alone is now larger by market value than the entire MSCI Emerging Market Index at its inception in 1993. While these giants may make the sector appear expensive on a price/earnings basis compared to the rest of the stock market, this ignores the different growth prospects for the sector as a whole. In aggregate, tech stocks are in fact trading close to their own long-term historical averages (see Figure 1).
Stronger economic growth and a potential boost to capital expenditures from the US tax changes should provide tailwinds for these stocks. At the same time, tech companies tend to be less levered than other sectors — an advantage in an environment that is increasingly sensitive to rising interest rates — helping support our positive near-term outlook.
Tech Sector Shifts for the Long Run
There are, however, three longer-term shifts that investors should be aware of. First, companies are seeking new revenue streams to maintain high growth rates. Facebook and Google, for example, rely almost entirely on advertising revenues, with implicit 15% to 20% annual increases priced into their shares for the next decade. But when they already account for 80% of new online ad sales, they will need to generate revenues from elsewhere to sustain this kind of growth. And there is no guarantee that developing new sources of revenue will be successful. Global tech giants do, however, have a potentially lucrative ace up their sleeve: monetizing the vast amounts of data they collect about their users. Amazon, for example, is a hybrid tech and consumer company that has moved into groceries not simply to profit from food sales but to amass consumer behavior data that can be mined for future profits.
But, as we have seen, this kind of expansion presents its own risks, both financial and political. Regulators in Europe are already concerned about protecting personal data, as well as encouraging new sources of innovation. Other countries such as China, India, Japan and Australia are rapidly following suit. The US is to launch a probe into the alleged mishandling of data by Facebook, paving the way for more scrutiny of the sector in general. Companies will need to adjust their strategies and business models to reflect evolving notions of privacy and consumer rights and address regulatory concerns to a greater extent than before. Meanwhile, blockchain technology could one day empower individuals to manage and commercialize their own information. Tech giants are also vulnerable to escalating trade tensions between major powers. The US and China may seek to shut out opposing national champions from their home markets, creating technological variation across different regions and eroding the spillover benefits of a shared global platform.
Second, the tech sector is dividing more clearly into winners and losers, as illustrated by the rise of cloud-based computing. The migration to the cloud is leaving behind hardware vendors, such as IBM and HP, and bolstering the likes of Microsoft and Salesforce that have adopted cloud-based models. Cloud computing hosted by fewer servers has made information storage more efficient, reduced costs for customers and decreased the amount of piracy, creating a competitive advantage for US firms who were the first movers in the space. So in this sector, unlike others, it can make sense to continue riding the growth of winners rather than invest in stocks just because their valuations are lower, as they may be cheap for a reason.
Third, providers are moving from old-style licensing, where users pay upfront once for copies of software, to subscriptions that users renew annually. While subscription-based models can increase sign-up costs for companies and reduce near-term returns, they create long-term, bond-proxy cash flows and extend the lifetime value of each customer. This shift helps explain why some valuations look stretched on current earnings but may prove to be fair value over the long term, and why the sector appears more mature, more defensive and less volatile than it did a decade ago. In the past, technology companies were mostly funded by cash and equity, but thanks to more predictable and higher quality cash flows, they now form a larger proportion of the credit markets.
Valuing Companies with Intangible Assets
Given the increasingly complex backdrop for tech companies and the pressure to generate growth, it is more important than ever to be able to value individual stocks as accurately as possible. Back in the dot.com bubble, investors came up with a variety of ways to justify unbridled valuations, few of which managed to distinguish between the companies that collapsed in the subsequent crash and those that went on to thrive. The challenge today is similar but greater: find a company’s true value that is not being captured by standard accounting practices and valuation metrics, without creating false signals.
Currently, most intangible assets such as algorithms and drug pipelines are not accounted for in firms’ balance sheets. However, as a growing proportion of the economy is built on these types of assets, it is becoming ever more critical to understand the longer-term value they represent. To distinguish between stocks that look the same on paper but may have very different future earnings, our quantitative analysts have been investigating alternative ways to model intangibles.
One approach is to capitalize the value of research and development (R&D) spending and amortize it over its estimated lifetime — as we would ordinarily depreciate a tangible asset. The amortization period depends on the asset. For example, a software program may reduce in value over four years and a newly developed drug over a decade, while new drugs might actually increase in value as they progress through the trial phases.
Even in the early stages of development, this R&D factor has produced meaningful changes to our existing earnings forecasts and the variance around those forecasts, refining our ability to select those companies most likely to outperform within a particular sector. It also highlights significant differences in relative value between industry peers and, in our view, offers the potential to generate better long-term returns for investors. This could be especially useful in the technology sector where missing out on long-term winners and buying cheap losers can be particularly costly.
So as investors look for opportunities in the current market environment in which equity valuations are not cheap, technology is one sector where we continue to find relative merit — from a top-down macro viewpoint and among individual companies. While a more intrusive regulatory environment could cause bumps along the road, from a strategic perspective, technology should continue to drive growth and innovation. Companies will need to be more circumspect about how they mine data, interact with governments and seek to create new revenue streams, but for now many have significant earnings strength and should benefit from broader economic growth. Over the long term, new valuation techniques should help investors ensure that their portfolios include not only today’s leaders, but also tomorrow’s innovators.
1Source: S&P 500 Information Technology Sector, Bloomberg
3Source: The Economist – January 20, 2018
Price-to-Earnings (P/E) Ratio: A valuation metric that uses the ratio of a company’s current stock price versus its earnings per share.
S&P 500® Index: A market value weighted index of 500 stocks that reflects the performance of a large cap universe made up of companies selected by economists.
Standard Deviation: A measure of dispersion around an average.
The views expressed in this material are the views of Gordon Kearney and Kishore Karunakaran through the period ended March 21, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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