Is it worth staying with tech funds?

We eagerly consume products and services from tech companies: Amazon, Netflix, Facebook, Google, Microsoft, Apple, and those are just the mega brands – there are plenty more. 

Tech businesses dominate the global stock market. Companies listed on the US tech-focused Nasdaq index have a total value of more than $24tn (£19tn). That is way ahead of the entire UK stock market.

But 2022 has been sobering: Nasdaq is down 26 per cent so far this year.  

Some commentators are comparing the recent pull back in tech to the bursting of the tech bubble in the year 2000. This is a poor comparison. First, the quality of fundamentals is not comparable.

Tech company valuations then were dramatically higher than the recent tech peak in November 2021. In 2000, the average price-to-forward-earnings ratio had reached 113 times. In November 2021 the average was 40 times. 

It is the same pattern for the 20 per cent of the most expensive tech stocks that are trading at a much lower level. That said, even after recent falls there is still a risk that the higher priced tech will fall further.

Market correction

So where are we now in the market correction of tech? The higher interest rate related hit to valuations has now been largely reflected in prices. That said investors should be wary of unprofitable technology companies. 

The reason for this is that in a higher interest rate environment, investors can get a better return on their money in bonds or on deposit. That makes them less willing to fund growth if the prospect of profitability is years away and if the cost of funding future growth is likely to be higher.

What of the impact of inflation on the operations of tech companies themselves? Do they still have the pricing power to put prices up to protect their margins from sticky inflation? The fact is that some do and some, as we are finding out, do not. 

Retail demand for tech shares must come off the boil.

The recent tech earnings season in April painted a very chequered picture. The reason is that year-over-year comparisons were distorted by the strong revenue boost these tech companies enjoyed during the Covid pandemic.

Added to that, this year there have been (hopefully transitory) headwinds from geopolitical discord impacting advertising demand at Meta (owner of Facebook/Instagram) and Alphabet (which owns Google), and supply chain bottlenecks for Apple. 

So given all of this, and with a substantial fall in tech prices behind us, what is the outlook?  

Triggers for positive momentum

Beware, fragilities remain. For things to move back onto a positive momentum the triggers below need to happen.

Post-Covid trends have to normalise. After the Covid-fuelled demand boom came the realisation that this would not continue in more normal times. That meant alarmed investors questioned the durability of growth for certain Covid beneficiaries, and share prices fell sharply.

Indeed, for some high-flying consumer internet businesses it is plain they were only enjoying a temporary sugar-rush, such as the connected fitness company Peloton.

Added to this there was a tendency for the largest beneficiaries of Covid to be overly enthusiastic about the sustainability of the growth they were enjoying. Netflix embarked on ambitious levels of investment in content, Amazon ramped up logistics capacity and Meta embarked on new business ventures. 

Ultimately, these concerns are transitory, and these investments should be source of growth in the future.  

Retail demand for tech shares must come off the boil. Retail shareholders participation in equity markets reached a record high in 2021. True, some retail sentiment is turning bearish with some signs of outflows, but there is no capitulation yet.

The main evidence for this is Cathie Wood’s Ark Innovation ETF, which still has inflows and even had its biggest inflow in a year in recent days. Signs of massive equity outflows on retail will indicate a market bottoming. 

Even with these triggers the stark fact is that tech investment in the coming months will be different from the past 10 years. 

Over recent years, low interest rates and abundant capital available for investment have been a massive tailwind for passive management in tech. The new interest rates regime we now face will see the return of active management. Not all tech companies will survive.

Added to that, the recent correction has been indiscriminate. The fundamental value of companies has been largely ignored. As a result, opportunities – mis-pricing of good businesses – are building up.

Once the inflation trajectory stabilises, wiser minds will emerge and there will be a shift back to assessing fundamentals.

For some internet businesses it is plain they were only enjoying a temporary sugar-rush.

Anomalies are already evident. Some companies trade at lower valuations than before Covid, despite having higher level of activities, pricing power, a high return on capital and high margins, yet their demand for capital is modest. 

Take software. Software company multiples are below their five-year average. But the sector has rapidly adopted a cloud-based subscription business model. This is significant because it brings resiliency, visibility and pricing power, valuable attributes in a persistent inflation/slower growth environment.

Additionally, the digital transformation trend is just starting. Currently public cloud spend is only 10 per cent of total IT spending – global IT spending amounts to $4tn.

There will come a time to switch back to some big tech companies. For Facebook (Meta) for instance, we expect revenue trends later this year to accelerate. Given it is trading around 14 times earnings, a significant discount to the market multiple with all stock-based compensation reflected, makes it an attractive long-term holding.

Tech investors should watch, and wait. But when the triggers come, do not tarry.  

David Older is head of equities at Carmignac