What next for the big tech stocks?

James Dowey, who manages a range of technology-focused funds at Liontrust, says we are “at the start of a new cycle in technology”, as a consequence of both fresh technology coming to the market and of the behaviour of existing technology companies. 

He says that while equity markets have generally struggled over the past year, “technology has been a bit of a bright spot. But the reality is that for many of the largest companies, the share price gains have been a function of earnings growth rather than just multiple expansion.

"For example, multiple expansion accounts for 2.5 percentage points of the share price gains of technology companies over the past decade, which is not just a small proportion of the total gains, but also not radically different from the ratio for the FTSE 100 in the same time period, which is 1.9 percentage points.” 

Dowey says many of the largest technology companies also screen positively when it comes to achieving return on equity from the investments they make, and feels this qualifies many such businesses as quality stocks, rather than cyclical or speculative businesses, which he says if often how they are portrayed. 

Assessing the outlook for technology growth stocks makes the traditional asset allocation decision more complicated.Chris Iggo, Axa Investment Managers

He feels one of the factors that highlights the change in the investment profile of such businesses is that “they have already had their recession, they had reduced workforces substantially, cut costs, and while recession has been much talked about in the wider economy, it hasn’t happened yet, the CEOs of tech companies have largely behaved like CEOs are expected to behave.” 

The notion that the largest tech companies have evolved into more reliable businesses is not completely disregarded by David Hogarty, senior portfolio manager at KBI Global Investors.

He says in the current environment, “the quality of a company is increasingly important as economic conditions may worsen.

"The issue I have is that many of these companies are more cyclical in nature than the market presently realises, Meta, for example, which is the company that owns Facebook, generates a lot of its revenue from advertising, and advertising is a cyclical business – I’m not sure the market fully appreciates this cyclicality.

"But generally speaking, we think a lot of the companies are good quality, but it’s about valuation.

"For example, analysts expect Apple to grow its earnings by 7 per cent next year, and while 7 per cent is OK, its actually the same forecast as for the FTSE 100, yet the FTSE 100 is far cheaper, so as an investor you are paying less for the same earnings growth with the FTSE.”

It is for this reason Hogarty is overweight UK equities right now, though he does have an investment in Microsoft. 

He says the growth trajectory of some of the largest tech stocks is actually relatively unattractive, “but they have been able to make their profits grow by an accounting technique around how they depreciate their mainframes. Apple used to depreciate them over three years, now they depreciate it over six years, and that has added billions to their earnings in recent years.”

Artificial intelligence 

Dowey says that while many of the largest technology companies have quite a mature growth profile, their future growth potential has been enhanced by the advent of advances in AI. 

He says: “The pace at which something like ChatGPT has been adopted is much faster than the pace at which the internet was adopted. The scale of the opportunity is massive and it’s happening now.

"Of course there is hype – our view is that the best way to invest in these things is to look at whether the innovation that is coming, will it make something that already happens cheaper, or better or both? I think if you do that, then you can get an understanding of the investment case without the hype.” 

Dowey says another feature he looks for when examining the investment case for a company in the technology universe is that it is the principal focus of the business, rather than a sideline. 

In this regard he compares the performance of the streaming service Netflix relative to that of Disney. He says the latter has struggled to grow as the company has an array of other operations that also require capital. 

While there is a lot of focus on AI, in terms of the stock market it has really benefited the share prices of just half a dozen or so stocks.David Hogarty, KBI Global Investors.

Hogarty describes AI as a “wild card” when it comes to constructing a portfolio. He says the effectiveness of the technology is not really in doubt, but his scepticism is “around how it can be monetised.

"At present, while there is a lot of focus on AI, in terms of the stock market it has really benefited the share prices of just half a dozen or so stocks. And those stocks are now at a valuation that we don’t like.” 

Chris Iggo, chief investment officer for core investments at Axa Investment Managers, says that “there seems to be a shift in macro momentum” right now, with a growing consensus that interest rates have peaked.

But his current view is that it may be bonds that are the greater beneficiary of this in 2024, rather than equities. 

In relation to technology stocks, he says: “Assessing the outlook for technology growth stocks makes the traditional asset allocation decision more complicated.

"Are the future growth benefits of AI compelling enough to buy stocks today that are trading on very high multiples? The S&P 500 Information Technology index is currently trading with a price-to-earnings ratio of 28 times – more than 5 per cent lower in terms of earnings yield compared to the current yield on high-yield bonds.

"However, valuation has rarely stopped them. These are companies with strong balance sheets, little debt, a lot of cash, and producing goods and services that enterprises and consumers want.”

He says this has helped broad equity market performance in recent weeks, but is sceptical that earnings growth expectations currently baked into valuations will be achieved.

Iggo says: “The bottom-up consensus for the MSCI All Country World equity universe is for 10 per cent growth over the next year. That is more than achieved in 2023 (so far) with a much higher pace of nominal growth. If those growth estimates are to be met, it puts even greater pressure on AI-related technology stocks to deliver.”

Erin Browne, portfolio manager for asset allocation at Pimco, says that US equities are generally trading at valuations above their long-term average, but says if one excludes the seven largest stocks, then the valuations are at around long-term average levels. 

Her view is that with earnings expectations so high, the prudent thing may be to focus on companies already demonstrating they can achieve profits, rather than those which have valuations based on future expectations.

David Thorpe is investment editor at FT Adviser