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 took precedence over profitability, and Corona accelerated the digitalisation of entire sectors and areas of life. In this constellation, they were the darlings of investors. But since the beginning of 2022, that has changed. The structural drivers, especially digitalisation, have not disappeared, but the monetary tailwind has turned into a headwind due to the interest rate turnaround: Financing growth now costs more. There are also geopolitical risks. In this situation, many investors put profitability before growth. The market is currently adapting to this new environment. The Nasdaq 100, which reflects the performance 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 per cent in April, inflation in the US rose to 8.6 per cent in May, the highest level since 1981, mainly due to higher commodity prices and supply chain problems. Thus, the pressure on the US Federal Reserve to raise interest rates further is increasing. As a result, yields on 10-year government bonds rose to 3.3 per cent. Higher interest rates hurt technology stocks because future profits are discounted at a higher rate, which in turn reduces the present value of the company. Higher inflation also weighs on consumer sentiment.
Tech companies must lower growth expectations
This combination of inflation and poor consumer sentiment is making itself felt in many technology segments. Companies that had built a high base from the Corona years and grew strongly are now having to scale back their forecasts for the current year. In particular, companies from the e-commerce, social media and advertising segments are seeing their growth rates decline. After Snapchat, for example, had already struck a cautious note in April, the outlook was reduced once again in May due to the poor economic environment and declining consumer momentum. Snapchat, as a social media company, relies on customers spending money on various types of ad products on the platform. However, in times of economic uncertainty, such spending is often the first to be reduced. In this respect, many tech companies and start-ups are also now looking at cost-cutting options. For example, new hires are being postponed for now (Snapchat, Netlifx, Microsoft, Facebook, Amazon, Gorillas, Klarna, etc.), or individual employees are even being laid off. Tesla, for example, announced a global hiring freeze and is looking into reducing its workforce by ten percent.
Investors act as fire accelerators for tech stocks
Another factor acting like a fire accelerant for the technology sector is investors reducing their sometimes heavy overweighting in the sector. In the heyday of the Corona pandemic, when many people were sitting in their home offices, non-professional investors stemmed around 30 percent of the trading volume of the so-called "Corona winners", including companies like Peloton, Netflix or Zoom, via trading platforms like Robinhood. Now it is less than ten percent of the trading volume, and most investors will have sold their positions with losses. But professional investors have also fuelled the sell-off in recent months, fuelling sector rotation. According to Goldman Sachs, hedge funds trimmed the technology, consumer cyclicals and services sectors by 15 per cent in the first quarter and built up energy, materials, industrials and banks by 13 per cent.
Here, however, one has to differentiate more precisely. Some of the trends fuelled by the pandemic have disappeared, but others have gained momentum and will drive corporate sales growth. Thus, the comparison with the "dotcom bubble" of almost 20 years ago is somewhat misleading. Some business models from back then existed only on paper, were unprofitable or not real. This has changed in the past 20 years. Favoured by demographics and changing customer behaviour, there has been a sustained shift towards digital technologies and services, which are now disproportionately profitable and usually generate higher margins than traditional companies.
Mergers and acquisitions gain momentum
The current sell-off, and thus much cheaper valuations in an industry where underlying structural trends are intact, could now lead to more mergers and acquisitions. At the height of the dotcom 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 ratio of 24.1 in the Nasdaq 100. EBIT margins today in the Nasdaq 100 are also 20.1 per cent, above the S&P 500's 16.1 per cent, even though some of the Nasdaq companies are not yet profitable. From 2015 to today, average revenues of Nasdaq stocks almost doubled, while those from the S&P 500 rose by only 48 per cent. Net debt to EBITDA is 0.65x in the Nasdaq 100 and 1.0x in the S&P 500. These comparisons show that tech stocks are better positioned than they used to be and have also built up certain cash cushions through the good economic years in order to have liquidity for share buybacks, dividends or acquisitions in worse times. The sell-off could also be interesting for private equity investors. The private equity firm Argos Wityu, which analyses private equity transactions involving European companies, notes that the valuations of different sectors are converging. While buyers paid four EBITDA amounts more for technology companies than for other industrial companies in the final quarter of 2021, the difference shrank to one EBITDA amount in the first quarter. This is because interest in high-yield transactions in the private equity industry remains high. Advent, an Anglo-Saxon private equity firm, recently announced the closing of a new fund worth 25 billion dollars. It is considered the second largest fund in the world.
Demand for cyber security solutions is growing significantly
In the technology sector, companies that specialise in cybersecurity are particularly attractive. Due to the growing digitalisation of companies and the current conflict in Ukraine, the vulnerability to cyber attacks is also 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 rate of digitalisation in companies, simply to protect intellectual property. The industry is facing high investments as a result, so that global cyber security revenues could increase by almost 60 percent to 345 billion dollars by 2026. Back in January, US President Joe Biden announced that companies and government institutions would have to convert their networks to a zero-trust architecture by 2025. The top dog for vertical security solutions is Palo Alto with a market share of almost 20 per cent, 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 characterised by high margins and recurring revenues. The trend towards the cloud is unbroken and has even accelerated recently. Whereas companies often operated their servers themselves in the past, they now almost exclusively use external providers for the cloud. This offers the advantage that capacities do not have to be provided locally and can be easily adapted if necessary. The costs for operating or purchasing the servers are eliminated. Software could also have further potential. One of the big changes in recent years has been the shift from buying software to subscribing to it - the keyword is "Software as a Service" (SaaS). In the past, customers bought a software licence individually and installed it locally. Today, companies or private individuals use an application via the internet and pay for its use, not for the programme itself. Updates and maintenance of the software are no longer necessary, and the company providing SaaS service receives a monthly fee. The advantages are calculable, recurring revenues, a stable cash flow and lasting customer loyalty - but also a certain dependence. Some software companies, including Adobe, Salesforce, Intuit or Autodesk, can record over 90 percent of their revenues as recurring. Such reliable revenues are interesting for investors especially when the economic situation is uncertain.
At the moment, one has to analyse exactly which technology companies might be worth investing in. However, every sell-off also offers opportunities, and in some cases companies have slipped far below their average valuation of recent years. Selective analysis and selection processes are therefore extremely important. A possible recession could even help technology stocks: Inflation would cool down, the pressure from the interest rate side would decrease, and growth could be financed more cheaply again. What also speaks in favour of technology stocks: they are less dependent on commodity prices and supply chains and can usually pass on price increases well to the customer.
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