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THE STORY OF TECH:
WILL THE BULL RUN LAST?

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David Lerche

Head of Equities

As investment professionals, we use the concept of an ‘investment clock’ as a tool to give us the correct perspective of our current position in global economic and investment cycles based on interest rates and economic momentum. In contrast to other asset classes, technology stocks have historically performed well no matter where we are in terms of the ‘clock’. What are the reasons for this, and can we expect the long bull run of these stocks to continue?

Our own analysis of the average monthly returns of various asset classes since 1995 has revealed that the MSCI World Technology Index has substantially outperformed the broader market over most of this period. Almost regardless of the stage of the cycle, and despite the significant correction from 2000 to 2003, tech has done well over the past 26 years.

Why have tech stocks consistently outperformed while the performance of other asset classes has ebbed and flowed as the cycle continues? In our view, there are several reasons, including:

  • Continual extensions of the expected growth runway. Market participants typically only model and are willing to pay for around five years of high growth, plus another five-year transition period, after which they expect companies to grow in line with the overall economy. The tech sector as a whole, however, has surprised the market with the consistency of its growth – for example, Google has grown its revenue by at least 15% in 19 of the 22 years since it listed. As long as companies such as Google continue to deliver, the market will keep modelling high growth. The risk is, of course, that once a company disappoints, the market will reduce the modelled high-growth period from 5-10 years to 1-3 years, which tends to have an outsized impact on valuations.
  • Tech has proven to be more resilient than expected. Among the first lessons most investment professionals learn is that high reward is typically associated with high risk. This was certainly true in the first three years of the 21st century, when the Nasdaq fell by 67%. However, the outperformance of the tech sector through both the great financial crisis and later the Covid-19 crash, belies such views. Investors are willing to pay high multiples for businesses that deliver both growth and resilience.
  • Cash-rich balance sheets. At the end of 2020, Google, Microsoft and Apple all had more than US$50 billion in net cash on their balance sheets. Even Tencent is sitting on net cash. Not only does this reduce financial risk, but it provides optionality for these companies to invest in new growth avenues.
  • Moore’s Law states that computing power doubles roughly every two years, which makes a mockery of the progress in vehicle fuel consumption, which improves by only about 3% per year. When the physical limits within which engineers must operate are expanding so rapidly, there is far greater scope for a company’s revenue to follow suit as previously unworkable ideas become feasible. Imagine trying to watch Netflix in the days of dial-up modems.

SIGNIFICANT CHANGES

The tech space has changed significantly from 26 years ago, when the likes of Netscape and Web.com were among the top five most valuable tech stocks. And yet, the sector overall continues to perform well. The tech environment has now become so broad that indices have split it into different parts, the largest being communications services and software.

When assessing tech stocks, it’s worth looking at other secular growth industries over the years and how long their performance lasted. Railway stocks did so well in the late 1800s that they made up half of the US market capitalisation in 1900, and yet they faded thereafter. Motor vehicle stocks were the darlings of the first half of the 20th century and the sector had the highest 30-year return to 1956. Subsequent years saw the birth of computer hardware companies, which delivered the best returns of the 1950s and 1960s, while coal miners gave the most favourable returns in the 30 years to the mid-1980s. The data varies materially, but major cycles tend to last around 30 years.

ULTIMATE SCALE BUSINESSES

What we love about tech as a whole is that these are the ultimate scale businesses, and many are natural monopolies with strong network effects. They sell ideas and access rather than physical goods and thus require both less capital and less effort to grow. For example, Facebook has zero incremental cost when a new user signs up, yet it can generate incremental revenue. Unlike car companies, tech businesses don’t have to build new factories in-country to enter new markets, and they require no raw materials.

While we can of course not peer into a crystal ball and predict the future, in the end, we suspect that it is their status as natural monopolies that will ultimately slow the profit growth of mega-cap tech stocks like Facebook and Google, via regulation. Indeed, it was the creation of antitrust laws that ultimately drove the breakup of Standard Oil. Regulation is already limiting the ability of tech companies to buy businesses, so they may be unable to take advantage of their strong balance sheets to buy competitors such as YouTube or Instagram.

VALUATION MATTERS

For the reasons set out above, we believe that the tech sector will continue to increase earnings ahead of the overall economy, with government intervention the unknown potential damper on growth. The problem for investors is that the broader market holds the same opinion, which is now reflected in the share prices of many tech companies, reducing prospective returns.

In many instances, valuations are stretched and pose a clear risk to investors. The Nasdaq is now trading at a 30 times forward price-to-earnings (P/E) multiple – 50% higher than its average over the past 15 years. So while we like the earnings growth story, the prospective returns for shareholders in US tech appear less attractive. With Microsoft trading at a 33 times forward P/E multiple – over 80% above its 15-year average – our global portfolios have recently reduced exposure to this share.

Investors’ fascination with US tech, however, also means that other areas of the market have received less attention – and it is in these areas that potential opportunity lies. Asian tech, which has been hit by regulatory concerns, offers many of the characteristics we like – but at more palatable valuations, which is why we recently added to our Prosus exposure. We also see opportunity in certain global medical tech and pharma names.

A STRUCTURED SOLUTION

For investors who would like exposure to the high-potential fields of technology and innovation, but who are deterred by the high volatility and hefty price tags in this industry, the experts at Sanlam Private Wealth have crafted a new structured solution.

The SPW Guaranteed Global Innovative Technologies Note offers you smart access to an index of the world’s top 100 companies at the forefront of technology and innovation, including artificial intelligence, the internet of things, healthcare and automotive innovation, robotics, and data computing and processing.

The tech note offers full participation on the upside, but it also provides complete protection on the downside, so you don’t have to risk your money to grow it to its full potential – in essence, you’re getting the best of both worlds.

If you’d like more information about our new tech note and how you can invest, please speak to your portfolio manager.

We constantly challenge the norm. Our investment process is a thorough and diligent one.

Michael York has spent 18 years in Investment Management.

Michael York

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