By Darius McDermott, managing director of FundCalibre
Technology has outpaced all other sectors for much of the past decade. Its annualised return over the past 10 years is 8.3% ahead of its nearest rival, the consumer discretionary sector.
The problem is that a lot of this astonishing performance is attributable to a relatively small number of companies, and the outlook for those companies is less certain. Capturing growth in the technology sector may require a more nuanced approach from here.
The technology sector has unique characteristics that separates it from other parts of the market. It continues to embed itself in new industries, moving in, disrupting them and then moving on again.
Car companies, for example, no longer rely on superior mechanics for their competitive edge, but their technological prowess instead. The payments industry has also been revolutionised by technology in recent years, with nimble fintechs challenging existing bank networks.
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High street retail, advertising, and education have all been disrupted by technology. This gives technology unparalleled structural growth qualities.
However, share prices have undoubtedly been supported by the low interest rate environment, which raised the value of long-term growth streams.
Equally, the sector has been prone to bouts of hype and disappointment. Investors who bought the Nasdaq in March 2000 would have had to wait until 2015 to recoup their investment. As such, it is a sector where attention to valuations is crucial.
Are mega caps too expensive?
Valuations are a particular problem for the mega cap names. They may have had various collective labels over the years, but the performance of Meta, Alphabet, Apple, Microsoft, Amazon, and more recently, Nvidia and Tesla, has been astonishing.
In 2023, these seven names accounted for nearly two-thirds of the S&P 500’s total returns, even against a backdrop of rising interest rates.
Their success has largely been a function of astonishing earnings growth and they have come to dominate technology indices such as the Nasdaq. For many investors, these companies are synonymous with the technology sector.
Today however, these companies look increasingly expensive and some of them are flagging. Tesla recently reported slowing car sales and is facing greater competition from Chinese rival BYD. Its share price is down 32% this year – a lesson in how much shares can fall when a business disappoints on expectations. Apple has also seen its share price drop 12% this year as the market for smart phones has stalled.
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Nevertheless, fund managers continue to back some of these companies. The Martin Currie Global Portfolio Trust, for example, holds 21.6% of the portfolio in Nvidia, Microsoft and ASML, and 29.3% in technology overall. Manager Zehrid Osmani said that the growth trajectory needs to justify the valuation.
“When we look at the AI growth basket of over 50 stocks, there’s been a rapid appreciation,” he added. “Over the last 12 months, there has been a 60 per cent move in share prices, for earnings that have only moved 7%.
“Compare this to Nvidia, where the share price is up 280%, but its earnings have been upgraded by 380%. There has actually been multiple contraction. We want to focus on companies that can monetise from AI and where there’s likely to be earnings momentum.
“Microsoft is positioned across three fronts – its stake in OpenAI, their cloud provision, and their connection with enterprises.”
Osmani believes companies will increasingly need to use AI to retain their competitive advantage and is focused on the ‘picks and shovels’ that will benefit from increased corporate spend on AI.
The BlackRock Global Unconstrained Equity fund also retains a significant weighting in these mega cap names, but selectively. It holds 35% in technology against a benchmark weight of 25% and has Microsoft, Alphabet and ASML among its top holdings.
Looking beyond the headline names
Doug Brodie, manager of the Baillie Gifford Global Discovery fund, said the mega caps have been perceived as “digital utilities,” as they own, host and process data. As such, their role in the growth of AI is clear and tangible.
However, he argued that technology such as generative AI is ultimately interesting because of the new problems that will be solved with it, asking: “What can individuals or businesses now do that they couldn’t do before? What can be automated?”
He believes it is the ‘solutions’ opportunity that could be a source of growth for the technology sector over the next decade.
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This is likely to benefit smaller companies. It might include software providers that can help companies process and interrogate their data, or companies further down the semiconductor supply chain.
The IFSL Marlborough Global Innovation fund is also focused on technology companies beyond the mega caps. It has 46.6% in technology, including companies such as payments group Boku, water technology company Xylem, cyber security specialist NCC Group and Latin American retail platform Mercado Libre.
Manager Guy Feld aims to balance exposure across emerging winners and established innovators. He said: “Emerging winners will be smaller, less liquid companies, maybe with weaker financials, while established innovators will tend to be larger and more liquid companies, but usually with a lower growth rate potential as you’d expect.”
An established innovator would be tax compliance group Vertex, which makes software for indirect taxes such as VAT, sales payroll and important export taxes. Feld said: “The company is set to grow its use of artificial intelligence in both the preparation of its content and for critical areas such as customer support.”
An example of an emerging winner on the other hand, would be Gentrack, a New Zealand based company providing billing and relationship management software to energy and water utility companies.
By its nature, the technology sector will always deliver a unique set of growth opportunities. While these still include a number of the mega caps, investors need to be careful that they are getting the growth they are paying for.
Increasingly, the more exciting opportunities may be found further down the market cap spectrum, in less discovered areas.
