Why global tech stocks are not overvalued - TechCentral

Why global tech stocks are not overvalued

There is certainly a lot of volatility in the technology space right now, but some of the recent investor nervousness is being driven by interest-rate concerns.

If the US Federal Reserve moves too fast in raising interest rates, all market sectors are going to be hurt, not just technology. We really work hard at trying to understand what these types of businesses look like at maturity, but the highest-quality secular growth businesses in technology can outperform even in a fast rising-rate environment.

There is also risk around a global trade war. We think that’s the biggest problem for enterprise IT hardware companies that need to get their hardware out of China into the US, and it’s also creating some demand and volatility for semiconductor firms. There are some concerns about China from a macroeconomic standpoint, but outside of semiconductors and a couple of other individual companies, the Chinese economy doesn’t consume a lot of technology from US tech companies.

There has been some selling of the winners at cycle-end. However, we still think focusing on the secular winners is the right way to go, and that they can perform well in any market context. There has also been some speculation about merger-and-acquisition (M&A) activity in the sector and it has contributed to some volatility as investors try to figure out where the next area of spending or M&A is going to be.

And then there is a lot of regulatory uncertainty out there. Does Europe’s General Data Protection Regulation come to the US? Will we see a digital tax? And then just what is happening with the Chinese government?

We think the global economy is currently strong. The one caveat is that China’s recent GDP growth numbers were a little below expectation, but outside of that we think enterprise spending is very robust, especially for those vendors that are enabling digital transformation. We think consumer IT spending is fairly stable across PCs and smartphones. And we are seeing very good growth in new media and gaming.

Digital transformation

Our belief is that every business is going to need to go on a digital transformation journey, and ultimately they need to build relationships with their customers that are service orientated, subscription orientated and recurring, and that ultimately have data at their centre. And then they need to operationalise that data to extract more value out of their customers. If they don’t do that, they are at the risk of being disrupted by either a digital disruptor who comes into their market or an incumbent who makes the investments in technology that are needed to become digital.

So Exhibit A of that, of course, is what we have seen in retail and the major e-commerce companies Amazon and Alibaba coming in as disruptors. Exhibit B is what we are seeing in transportation right now with on-demand ride services like Uber. And of course, Exhibit C is a company like Airbnb. I think they have the world’s largest set of properties for hotelling, and yet they own no properties on their own. It’s a pretty remarkable type of story.

The author, Jonathan Curtis, says tech stocks are still generally offering really good valuations

There are a number of really important sub-themes within digital transformation, including artificial intelligence, cloud computing and the Internet of things, which we think is a stealth opportunity around data and around digital transformation. And fintech and digital payments—and the amount of data that flows from that—are exciting.

The sub-sectors we like in technology right now are cloud computing and application software, which we think is a stealth play on AI given all the data collected around usage. We really like Internet e-commerce and advertising companies and the companies doing new media on the Internet. We like financial IT services and semi-cap equipment; we think that’s a deep value play on AI and cloud.

There are always sub-sectors in technology that are overvalued or undervalued — that’s just how markets operate. Broadly, in tech, we think current valuations are reasonable. If you look at the next 12-month price-to-earnings multiple on a broad basket of tech stocks, there is a 7% premium to the S&P 500 Index. If you take out the cash component out of these tech companies (which are typically cash-rich, versus most other companies in the S&P 500 Index which are net-cash negative) then they are basically trading at the same multiple.

Some of the highest-quality business models are in technology companies.

Corporate tax reform is also a potential catalyst for tech companies. We know that the single best leading indicator for enterprise investment in IT is changes in corporate profitability, and pretty much every US company just became more profitable as a result of corporate tax reform.

In addition, a lot of capital that was overseas in these big US tech companies has come back home and is being applied for very shareholder-friendly things. Dividends are being increased broadly and there is strong share repurchase activity, as well as a bit of M&A.

So, the tech space generally offers really good valuations, some of the best quality and structural growth around this idea of digital transformation.

What we try to do in these environments is focus on the fundamentals and really try to understand what these businesses will look like at maturity. We think the margin structures are excellent and investors are going to need to start thinking about tech as not just a sector but as core—really something that they need to own for the long run.

  • Jonathan Curtis is vice president and research analyst with Franklin Equity Group