DJE expert Kerkhoff: Technology – Structural trends are intact

For a long time, technology stocks enjoyed a special environment: With extremely low interest rates, growth was easy to finance, growth ranked before profitability, and Corona accelerated the digitization of entire sectors and areas of life. In this constellation, they were the darlings of investors. But that has changed since early 2022. The structural drivers, above all digitization, have not disappeared, but the monetary tailwind has turned into a headwind as a result of the interest rate turnaround: financing growth now costs more. There are also geopolitical risks. In this situation, many investors prioritize profitability over growth. The market is currently adapting to this new environment. The Nasdaq 100, which reflects the development of the 100 largest US technology companies, has lost a good 31 percent since the beginning of the year, while the S&P 500, the stock index of the 500 largest US companies, has “only” lost 21 percent.

While we saw inflation of 8.3 percent in April, inflation in the USA rose to 8.6 percent in May, the highest level since 1981. The main reasons are higher commodity prices and supply chain problems. As a result, the pressure on the US Federal Reserve to further raise interest rates is increasing. As a result, yields on 10-year government bonds rose to 3.3 percent. Higher interest rates hurt technology stocks because future profits are discounted at a higher rate, which in turn reduces the company’s present value. Higher inflation is also weighing on consumer sentiment.

Tech companies need to scale back growth expectations

This combination of inflation and poor consumer sentiment is being felt across many technology segments. Companies that had formed a high basis from the Corona years and have grown strongly must now lower their forecasts for the current year. Above all, companies from the e-commerce, social media and advertising segments should be mentioned here, whose growth rates are declining. After Snapchat, for example, had already sounded cautious in April, the outlook was reduced again in May due to the poor economic environment and the slowdown in consumer spending. As a social media company, Snapchat relies on customers spending money on different types of display products on the platform. In times of economic uncertainty, however, such spending is often the first to be reduced. In this respect, many technology groups and startups are now examining cost-cutting options. For example, new hires are postponed (Snapchat, Netflix, Microsoft, Facebook, Amazon, Gorillas, Klarna, etc.), or individual employees are even fired. Tesla, for example, announced a worldwide hiring freeze and is considering reducing the number of employees by ten percent.

Investors act as fire accelerators for tech stocks

Another factor that is acting like a fire accelerator for the technology sector is that investors are reducing their overweight in the sector, some of which are large. At the height of the corona pandemic, when many people were working from home, non-professional investors accounted for around 30 percent of the trading volume of the so-called “corona winners”, including companies such as Peloton, Netflix or Zoom, via trading platforms such as Robinhood. Now it’s under 10 percent of trading volume, and most investors will have sold their positions at a loss. But professional investors have also fueled the sell-off and fueled the sector rotation in recent months. According to Goldman Sachs, hedge funds shed the technology, consumer discretionary and services sectors by 15 percent and added 13 percent to energy, materials, industrials and banks in the first quarter.

Here, however, one must differentiate more precisely. Some trends fueled by the pandemic have disappeared, but others have yet to gain momentum and will drive corporate revenue growth. Thus, the comparison with the “dotcom bubble” from almost 20 years ago is somewhat misleading. Some business models from back then only existed on paper, were unprofitable or not real. That has changed in the past 20 years. Favored by demographics and changing customer behavior, there was a sustained shift towards digital technologies and services, which are now disproportionately profitable and mostly generate higher margins than traditional companies.

Mergers and acquisitions are gaining momentum

Due to the current sell-off and the resulting significantly cheaper valuations in an industry in which the underlying structural trends are intact, mergers and acquisitions could now become more frequent. At the height of the dot-com bubble, technology stocks in the S&P 500 had a price-to-earnings (P/E) ratio of 62.3, compared to today’s P/E in the Nasdaq 100 of 24.1. Today’s EBIT margins for the Nasdaq 100 are 20.1 percent, ahead of the S&P 500’s 16.1 percent, although some Nasdaq companies are not yet making profits. From 2015 to date, the average turnover of the Nasdaq stocks has almost doubled, while that of the S&P 500 has only increased by 48 percent. Net debt to EBITDA is 0.65x on the Nasdaq 100 and 1.0x on the S&P 500. These comparisons show that tech stocks are in a better position than they used to be and that they have also built up a certain cash cushion through the economically good years in order to have liquidity for share buybacks, dividends or acquisitions in bad times. The sale could also be of interest to private equity investors. The investment company Argos Wityu, which analyzes private equity transactions relating to European companies, notes that the valuations of different sectors are similar. While buyers paid four EBITDA amounts more for technology companies in the final quarter of 2021 than for other industrial companies, the difference shrank to one EBITDA amount in the first quarter. After all, interest in high-yield transactions in the private equity industry remains high. Advent, an Anglo-Saxon investment company, recently announced the conclusion of a new fund worth 25 billion dollars. It is considered the second largest fund in the world.

The demand for cyber security solutions is growing significantly

In the technology sector, companies that specialize in cybersecurity are particularly attractive. Due to the growing digitization of companies and the current conflict in Ukraine, the susceptibility to cyber attacks is increasing worldwide. Whereas companies used to have to invest in analogue factory security to protect their warehouses, today they need digital security systems. The demand for cyber security solutions will increase at least as much as the digitization rate in companies, simply to protect intellectual property. The industry faces high investments as a result, so that global cybersecurity sales could increase by almost 60 percent to $345 billion by 2026. US President Joe Biden announced in January that companies and government institutions would have to convert their networks to a Zero Trust architecture by 2025. Top dog for vertical security solutions is Palo Alto with a market share of almost 20 percent, followed by Fortinet and Cisco.

The cloud and software sector is booming

There are also exciting investment opportunities for cloud and software providers, as these are often characterized by high margins and recurring revenues. The trend towards the cloud is unbroken and has recently even accelerated again. While companies used to operate their servers themselves, they now rely almost exclusively on external providers for the cloud. This offers the advantage that capacities do not have to be provided locally and can be easily adjusted if necessary. There are no costs for operating or purchasing the servers. Software could also have further potential. One of the major changes in recent years has been the switch from purchasing to subscribing to software – keyword “Software as a Service” (SaaS). In the past, customers bought a software license individually and installed it locally. Today, companies or individuals use an application over the Internet and pay for the use, not for the program itself. There are no software updates and maintenance, and the company providing SaaS service receives a monthly fee. The advantages are calculable, recurring income, stable cash flow and lasting customer loyalty – but also a certain dependency. Some software companies, including Adobe, Salesforce, Intuit or Autodesk, can book over 90 percent of their sales as recurring. Such reliable income is of particular interest to investors when the economic situation is uncertain.

At the moment you have to analyze exactly which technology companies could be worth investing in. However, every sell-off also offers opportunities, and some companies have slipped far below their average valuation in recent years. Selective analyzes and selection processes are therefore extremely important. A possible recession could even help the technology stocks: Inflation would cool down, the pressure from interest rates would decrease, and growth could be financed more cheaply again. What also speaks in favor of technology stocks: They are less dependent on raw material prices and supply chains and are usually able to pass price increases on to customers.

René Kerkhoff, Fund Manager, Internet, Tech, Retail & Automotive Analyst at DJE

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