By René Kerkhoff, analyst for the sectors technology, automotive and retail and fund manager of DJE - Mittelstand & Innovation at DJE Kapital AG
Cloud, Artificial Intelligence & Co. - Support in the crisis
The technology sector (IT) is one of the most important drivers of the global economy. Even the current corona pandemic does not change this. On the contrary: During and after the crisis, more demand for new digital solutions is being generated.
A glance at the indices shows the potential: The Nasdaq 100 alone that represents many of the US technology stocks had been risen by more than 300 percent since mid-2008. Meanwhile the S&P 500 almost increased 140 percent in the same period. It is not for nothing that the largest listed companies in the USA come from the technology sector in terms of market capitalization. In addition, most technology companies worldwide are based in America. Attractive regulatory conditions, low language barriers, targeted university support, good pay for talent and significantly better financing opportunities for venture capital are just some of the reasons for this pioneering position. IT covers all sectors of information, communication and data processing. Currently, the sub-sectors cloud, software and artificial intelligence (AI) are particularly promising.
IT sector with solid balance sheets and strong cash flows
Unlike the past the IT sector today is characterized by solid balance sheets and strong cash flows. This has led to rising dividends and share buybacks in recent years, resulting in increased returns for shareholders of IT companies. Since the U.S. tax reform, which took effect at the beginning of 2018 and made the recovery of profits accumulated abroad more attractive, the U.S. IT sector has been the sector that brought the largest amount of money back home. Substantial portions of this capital have since been channeled back to shareholders.
Not only the returns to shareholders increased attractiveness for investors also IT companies all over the world are benefiting from strong profit growth rates. Thanks to the advancing digitalization: technology has become a decisive success factor in all industries today. Those who do not keep up with the pace will quickly be out of the competition. Companies worldwide have realized how valuable their data is. Consequently, investments in software solutions, big data, artificial intelligence and cloud computing are increasing globally.
Cross-industry: Increasing investment in digitalization
According to the Gartner research institute, global spending on IT this year is expected to be $3.9 trillion. This represents an increase of 3.4 percent over previous year. For 2021 global IT spending is forecast to exceed four trillion US dollars. Efficiency improvements and cost reductions are becoming more and more important, and companies are increasingly investing in digitalization measures. However, the level of investment varies greatly depending on the industry.
The recruitment of suitably qualified employees, the expansion of cloud capacities, the expansion of software-controlled data analyses and the use of intelligent technologies are among the most important measures for making digitalization successful. The greatest importance is currently attached to investment in cloud capacities. The European market has been growing constantly in the area of digitalization for years. In an international comparison, however, the USA and also China are far ahead with significantly higher growth rates and a stronger foundation. Whether the European economy can remain competitive in the future depends largely on digitalization.
Crisis as an accelerator
The use of cloud services has increased significantly in recent years, with more than 70 percent of all IT services now being provided from a cloud. In times of home office, home schooling & Co. the trend may have recently become even stronger. Cloud services have the advantage that capacities do not have to be provided locally and can be easily adapted as required. While the cloud is largely operated by companies themselves, they rely almost exclusively on external providers for the data platform underlying the cloud. The increasing use of cloud services is therefore also increasing the dependency on the mostly non-European providers. Currently, the largest Cloud providers include Amazon, Microsoft, Alphabet and Alibaba.
According to Gartner, the global market for public cloud services will grow from USD 214.3 billion in 2019 to USD 249.8 billion in 2020. “Software as a Service" (SaaS) remains the largest market segment, which is expected to reach 110.5 billion US dollars in the coming year. Nevertheless, the estimated global cloud penetration rate is currently only between 10 and 20 percent. This shows the future growth potential of the market.
Subscription models: reliable revenues for software providers
Every day, people around the world use software consciously and unconsciously. In the case of a notebook or PC, the operating system is just as much a software as the programs installed on it and any data generated by it. But other systems are also software-controlled; here the software is firmly anchored with the hardware and is therefore called an "embed¬ded system". On one hand, we are now dependent on software in almost all areas of life - on the other hand, it makes us and our everyday life more efficient.
One of the major changes in recent years has been the switch to the subscription model. This is a (digital) business model in which the provider sells a defined service and the customer pays regularly for its use. The business model is old: newspaper subscriptions and club memberships are typical forms of subscription models. In the digital economy, however, the model is relatively new. On a large scale, it has emerged with "Software as a Service" (SaaS). Unlike traditional software distribution, where a software license is purchased individually and installed locally, in the subscription model, companies or individuals use Internet application with a browser and pay for its use, not for the program itself. Updates and maintenance of the software are not required.
A monthly fee per user is usually paid, often supplemented by an additional fee above a volume of data used. The advantages of this business model are recurring income, a stable cash flow and long-term customer loyalty - one could also speak of a certain dependency. Some software companies can post over 90 percent of their revenues as recurring. This is particularly interesting for investors in times when the economic situation is uncertain.
Europe: Watch out, don't lose ground!
US companies are particularly keen to invest in state-of-the-art software. The USA's global share of AI software, for example, is around 80 percent and Big Data's market share is over 50 percent. This enables companies to increase their productivity and efficiency. On the other hand, those who only use the technologies once they are already widespread and established will no longer be able to gain competitive advantages.
European companies are regularly not among the pioneers of new applications. Europe has only one major software company to compete with the USA - the global player SAP. Overall, Europe cannot currently compete with the market power of the United States and China. In general, Europeans need to invest more in software solutions to reduce their increasing dependence on the Americans.
Artificial intelligence: Foundation for tomorrow's technology standards
AI is able to learn independently, to recognize and correct errors. This makes AI a trend-setter for many sectors, including cognitive assistants, robotics, smart devices, automated analysis, image processing and medical diagnosis. Currently, AI is still a "niche topic" on which only a few companies are concentrating.
Most people associate AI mainly with autonomous driving or speech recognition systems. AI lays the foundation for the standards of tomorrow's technology. The USA and China in particular have invested heavily in the field of artificial intelligence in recent years: Spending on intelligent technologies has risen from 10 to 14 percent of the total IT budget. These investments have also led to numerous patent applications. IBM is the leader here with 8,920 patents, followed by Microsoft with 5,930 patents and various Asian technology companies, including Alibaba and Baidu. The US and China have the competitive advantage of relatively low data protection regulations, allowing companies to access large data sets that are essential for research and development in the field of AI.
Software industry - currently good opportunities in times of crisis
In general, technology companies offer good investment opportunities for investors. The sector is one of the few that combines largely solid balance sheets with high growth rates justifying the higher valuations.
The software sector is particularly exciting. It concentrates on high, scalable growth due to the tendency of growing investments in digitalization. It offers its investors steady cash flows even in uncertain times, driven by subscription models and thus recurring revenues. Due to their lower debt levels and mostly recurring revenues, software companies have a more defensive character and are not as vulnerable as cyclical industries, especially in times of crisis. The structural trend towards digitalization will accelerate even further as a result of the crisis, which will enable software companies to maintain higher growth rates in the long term even after the crisis is over.
Note: All information published is for your information only and does not constitute investment advice or other recommendation. Long-term experience and awards do not guarantee investment success. Securities are subject to market-related price fluctuations which may not be compensated for by the active management of the asset manager or investment advisor. This information cannot replace a consultation. All information has been provided with care and to the best of our knowledge at the time of preparation. Despite all due care, the data may have changed in the meantime. Further information on opportunities and risks can be found on the website www.dje.de. The sales prospectus and further information are available free of charge in German from DJE Investment S.A. or at www.dje.de The fund management company is DJE Investment S.A. DJE Kapital AG is the distribution agent.