The recent results from the technology sector confirm what most investors knew already: the technology companies have been the big winners from the pandemic. First quarter results from Microsoft, Amazon, Alphabet, among others, have exceeded even the most optimistic expectations. Few doubt that technology is a strong secular theme, but opinion remains hugely divided on whether it is still a good investment.
During 2020, it quickly became clear that the pandemic would accelerate certain key technology trends – digitisation, for example. In April last year, Microsoft chief executive Satya Nadella said the group had seen more than 200 million Teams meeting participants in a single day, generating more than 4.1 billion meeting minutes. He said: “We’ve seen two years’ worth of digital transformation in two months.”
This was supported by business surveys. A McKinsey Global Survey of executives found that companies had accelerated the digitisation of customer and supply-chain interactions and of their internal operations by three to four years. The share of digital or digitally enabled products in their portfolios had accelerated by seven years.
The latest set of technology results show that these early predictions were absolutely right. While there was some caution on the rate of growth beyond this period of rapid recovery, on the whole, the results demonstrated that faster adoption of new technologies was happening and was likely to endure.
However, investors remain extremely divided about whether this makes technology a sound investment today. This ambivalence is perhaps demonstrated by the lacklustre share price performance in the wake of these stellar results. In the two weeks since the results announcements, the S&P 500 is down 0.7%, compared to a drop of 4.7% in the Nasdaq. Fears about inflation, over-valuation and the durability of earnings growth beyond this early recovery phase have conspired to keep prices low.
Will Bartleet, chief investment officer at Pacific Asset Management, is clear that big themes don’t necessarily go hand in hand with share price appreciation. “The earnings and growth of some of these companies have been spectacular. However, it comes at the end of a 15-year bull market for growth stocks. Many have gone from being fairly valued to trading at extreme valuations. Covid has helped push them even further.
“Bond yields have collapsed, which is a huge tailwind to their valuations. We believe we are now at an inflection point. Cloud computing is not going to stop being a big theme, but investors can still buy value companies at very wide discounts and they are more geared into the recovery. Earnings for these companies are growing faster than share prices are recovering.”
He points out that throughout history, there have been important themes where investors haven’t made a lot of money: “Clean technology in 2007, for example, was a huge bubble. Share prices collapsed for two years and then went sideways for 10 years, even though clean technology continued to be vitally important. The same was true of the Internet in the late 1990s. Investors were absolutely right about the transformative power of the internet. It was just that they paid too high a price.”
Too big to comprehend
There is another argument, however. Chris Ford, manager of the Sanlam Artificial Intelligence fund, says that while there are pockets of valuation risk around the market, in some cases among the AI names, Wall Street simply doesn’t comprehend the scale of the disruption or the opportunity.
The extent to which the pandemic has forced companies to adopt innovative technology and the scale of this change is not widely understood, he says: “The most high profile example would be in the drug discovery space where the requirement to find vaccine solutions to address the covid pandemic required novel technologies to be brought to bear and disrupted very old working practices within the pharmaceutical businesses […] what covid required was not working in-vitro, but in-silico, approaching modelling in a different way.
“Those working practices forced to change are persisting in the post-covid world. Pharmaceutical companies are now expecting completely different things of themselves and the way they work to deliver drug pipelines. It’s incredibly important for all of us. Corporate digital transformation programmes are heavily inflected by artificial intelligence systems. It’s happening at a far faster rate than people think. Any CFO who didn’t think they needed to engage, now understands they have to.”
He believes this is “not even nearly” in the price of some shares: “Even if we assumed it was in the price of shares, it’s only there to the extent that we understand what the future revenue opportunity and cash generative capacity of these businesses looks like.”
He points to Upstart, saying the market fundamentally misunderstood the rate of adoption. “To the extent that I feel that these companies are continuing to operate at a very high level and to exceed expectations misapprehended by the investment community, I feel comfortable with valuations where they are.”
Caught up in the fairytale
In reality, these two arguments may not be mutually exclusive. The technology universe is vast and diverse and there will undoubtedly be parts of the market where the opportunity is not properly understood. Equally, there will also be areas where investors have extrapolated too high a growth rate from a high-profile trend.
Inevitably, high growth technology company face a headwind from higher inflation expectations, which is likely to weigh on valuations until pressures ebb in the latter part of the year. While this doesn’t diminish technology’s power as a long-term growth opportunity, more than ever investors need to ensure they aren’t just buying a good story.