Rarely is there any sector that has everything going for or against it, and that is certainly true of today’s Information Technology sector. The sector boasts an impressive profitability – the best across all 11 S&P sectors. More importantly, it is well positioned in the context of economic growth – even at a slower pace. Finally, we like its compelling fundamental and strategic outlook; inflating input and labor costs are spurring businesses to accelerate.
Near-term, secular trends in cloud computing, leading to enhanced use of VR, AR, AI, robotics, and 5G, amongst others, remain strong and enterprise IT spending, mainly around IT security, should be well-supported by strong corporate profit growth. However, the outlook for higher interest rates will likely be a headwind for valuations, especially considering that for a good number of companies the market has applied long-duration valuation models.
According to an MS research paper, some 40% of surveyed CIOs reported IT budget increases since the beginning of the year, versus 26% indicating decreases. This is one of the highest positive ratios since 2018. The report also shows some of the expected allocations:
- Spending priorities: Cloud Computing, Digital Transformation, IT Security. While IT Security is not top ranking in terms budget allocation, it is the segment that will not suffer any cuts due to eventual budget constraints.
- Structural trends are driving spending decisions: Software related spending is outpacing hardware related spending.
- U.S. related spending outnumbers EU related spending
Positives for the sector:
- Companies generally have strong balance sheets and earnings growth potential with low funding costs.
- Home office, financial services technology, and surging online retail are supportive of cloud-computing infrastructure and software.
- Long-term growth tailwinds are expected as businesses enhance productivity with tech investment.
- Companies in the technology sector tend to outperform the larger market for a long period of time
Negatives for the sector:
- Valuations are very stretched relative to the historical average, making higher interest rates a significant headwind.
- Capital expenditures are weak, albeit improving.
- Semiconductor prices are rising amid low supply and hoarding.
- The sector is highly concentrated in a few stocks.
- For the most highly regarded companies, valuations have expanded dramatically.
| Investment opportunities: |
|
The near-term is highly uncertain due to COVID-19 and the war in Ukraine. It should be opportune for investors to focus on technology companies that have attractive longer-term growth opportunities due to being established franchises in large and secularly growing addressable markets, such as software, cloud, and security. Secular trends remain strong and tech profits will likely recover to peak 2019 levels more rapidly than any other sector. However, valuations are high, and the sector’s defensive behavior during the pandemic gives us less conviction that it will outperform in the ensuing economic recovery. In this vein, we highlight Microsoft, Palo Alto Networks, Salesforce.com, Splunk, Fortinet, and Accenture. Investors looking for small cap exposure may look at Okta, Twilio, Block, Zuora, and Etsy. |