The fund manager’s view
John Stopford, head of multi-asset income and co-portfolio manager, Diversified Income Fund at Ninety One
US tech stocks drove much of the global equity bull market post financial crisis. Some of this performance reflected extraordinary innovation, increasing industry concertation, strong demand and the resultant ability of the sector to grow earnings even against the backdrop of weak global GDP growth.
We believe these drivers will continue to underpin the earnings power of US tech companies over the medium term.
However, tech stocks also benefitted hugely from falling real and nominal long-term interest rates, especially during the pandemic. These reduced the discount rates applied to future profits, pushing their valuations to rise to very expensive levels.
With bond yields normalising on the back of higher inflation and tighter monetary policy, a proportion of this valuation froth has come out of the market, but we believe this relative de-rating may continue in what looks like a different and likely higher average interest rate environment post-pandemic.
If we’re right, we expect near-term dividend payments to be more highly valued by investors, with less valuation support for long-term growth potential. Tech and US equities should trade at a smaller valuation premium to broader global equities as a result.
Our focus within the tech sector is looking for above-average dividend-yielding companies, with strong competitive positions and where the yield is underpinned by strong and resilient cash-flow generation.
Despite our current caution, we see opportunities at a stock level, in certain semiconductor design and equipment companies where barriers to entry are high and structural growth trends are likely to remain supportive, and also in some firms providing cloud services.
The fund buyer’s view
Isaac Stell, fund research manager, Parmenion
The Covid-era darlings have fallen from their perch in what has been a year of reckoning for US tech stocks. The period of low interest rates and easy money is arguably over, perhaps bringing an end to the outsized gains seen in US tech stocks during the past decade. The outlook in the shorter term looks bleak but are there attractively priced opportunities to be found?
Valuations have fallen quite considerably but using the Nasdaq as a yardstick, they are still around 12% above pre-pandemic levels. The declines experienced can be linked to the sharp increase in the risk-free rate. It is hardly surprising given the rate has been so low for so long, but have the falls also priced in the margin compression likely to be experienced in the coming months?
There is evidence to suggest that valuation declines precede earnings revisions, but nothing is certain. As Mark Twain is often quoted as saying: “History doesn’t repeat itself, but it often rhymes.”
The outlook for US tech stocks is sharply divided. Those which have consolidated their positions through the pandemic and achieved essential status, such as Microsoft and Amazon, should continue to deliver in line with expectations. However, many of the smaller and largely unprofitable tech companies, whose valuations shot up in frenzied trading during Covid, will likely struggle over the shorter term, in more uncertain markets and potentially a US recession.
From a fund buyer’s point of view, diversification remains key. Thematic allocations to US tech can and have worked in the past, but it would be wise to blend exposures to give portfolios the best chance of delivering consistent, risk-adjusted returns over the longer term.
The model portfolio manager’s view
Ben Gilbert, model portfolio manager, Sarasin & Partners
US tech stocks have been grabbing headlines recently for all the wrong reasons. These US mega caps were the markets’ saviour during Covid-19: one of the few pockets of the global economy that not only largely avoided the impact of lockdowns but actively benefitted as decades worth of expected growth was brought forward.
Alas, this could not last, and cracks were beginning to show by the end of 2021. Since then, the exalted valuations of these businesses have been hit by higher interest rates, and therefore higher discount rates applied to future profits. It’s a genuine slowing of their growth in line with an impending global recession.
As customers return to a more ‘normal’ relationship with their digital lives it marks a return to form for unloved ‘value’ sectors such as energy amid the invasion of Ukraine.
All in all there has been lots of short-term noise to distract investors and the markets’ usual irrational exuberance (and pessimism) has been on display. As thematic investors, we believe it is important we see through this noise and look to the fundamental economic reality.
Digitalisation and automation are key themes here at Sarasin and we see many of the US tech names as multi-year, even multi-decade, beneficiaries of above-average growth to which investors need exposure.
However, this cannot come at any price financially or at any cost to society.
Investors need to remain focused on the price they are paying for this growth and aware of the ESG risks, for example the impact on tech valuations as a result of policy interventions to regulate these markets more severely. Nevertheless, we think reports of US tech’s death are greatly exaggerated.
The analyst’s view
Richard Hunter, head of markets, Interactive Investor
The Nasdaq has taken the brunt of the selling pressure in US markets this year. However, despite the index’s 30% year-to-date decline, over the past five years it has added 63%. This is partly the result of recent strength. At the end of 2019, the index stood at 8,973, having put in a strong performance and rising for that year by 35%. In 2020, we saw an even stronger performance as the index rose by 44% to 12,888. In 2021, another 21% was added such that the index finished the year at 15,645.
With many of the larger tech companies trading at extremely high valuations given future growth prospects, these stocks are particularly sensitive to a rising interest rate environment. At the same time, interest rates should settle at a relatively low level by historical standards, which in turn could provide some future relief.
In the meantime, the continuing threat of regulation overhangs the sector, and the stratospheric rise of many of the big tech names may also have provided an exit point for some investors to lock in profits.
Despite the understandable rotation given the economic backdrop, it may also be fair to say that investors ignore the tech giants at their peril, since there is plenty of scope for further growth.
Many of them have dominant, and in some cases, unassailable positions in their market and are prime examples of what Warren Buffett would describe as having a “moat” around the business, namely a competitive advantage which allows the company to maintain both pricing power and higher profit margins.
As with so many dilemmas, the answer is neither black nor white, but usually varying shades of grey. It is possible for an investor to enjoy the benefits of diversification by perhaps holding both growth and cyclical stocks, particularly when the growth stocks in question are such behemoths in their field.
This article first appeared in the November edition of Portfolio Adviser Magazine
