Tech stocks have been on a tear this year. The rally may have legs, we believe. Disruptive innovations have long been driving tech companies’ performance, and are likely to continue to provide support. Yet tectonic shifts in technology are creating uneven benefits within the sector – and beyond. We advocate a selective approach to tech investing.
Disruptive innovations have fueled strong demand for tech companies’ products and services–underpinning the sector’s sustained out-performance. We compare some key metrics in tech stocks versus the broader global market: Tech companies have posted higher profit margins and stronger sales growth over the past five years, with vastly lower corporate leverage. Yet they trade on average at only a modest valuation premium. See the chart above. More tech disruptions are on the way, powered by fifth generation (5G) wireless technology and artificial intelligence (AI). These technologies are still in their early days, but the race among companies across industries to tap their potential should underpin future tech revenues and earnings. We see current valuations as fair on average. The sector is trading at a modest 5% premium to its five-year average, measured by forward price-to-earnings ratios – well below the 20% premium seen in June 2017.
5G, AI and beyond
High-speed 5G mobile technology is a step-change from the previous four generations. Greater bandwidths and faster Internet speeds are just the start. The key attributes of 5G–massive data capacity and ultra-fast speeds–could empower and accelerate the application of AI across industries, enabling advances in areas from driver-less cars to smart cities and tele-medicine. 5G trials have started, but wider deployment is unlikely until the early 2020s. Wireless carriers looking to gain a first-mover advantage are already deploying the pricey infrastructure backbone, to achieve a boost to existing 4G offerings while setting up to transition to 5G.
Semiconductor suppliers are potential early winners from this ongoing shift. They are set to benefit from a significant increase in demand for the data and infrastructure required to handle the network traffic. Fiber and testing companies also stand to benefit as 5G infrastructure is built out and new 5G applications are tested. The implications of tech innovation go beyond the narrowly defined tech sector. Think of the potential for autonomous and electric vehicles to disrupt the auto sector and related supply chains over time. Self-driving vehicles combined with greater prevalence of ride sharing could translate to fewer cars on the road. Such a scenario could also hurt the value of businesses such as parking infrastructure.
Within tech, we like semiconductor firms, thanks to a potential earnings turnaround this quarter. We prefer exposure to both U.S. and Chinese tech. The two countries are ramping up efforts to be the first to deploy 5G and set global standards, as part of their competition for global technological leadership. The tech sector faces its share of risks. A downturn in economic activity could temporarily hurt demand for technology products. Data privacy rules and anti-trust measures pose risks to popular tech companies that are now in the communication and consumer sectors. And we are mindful of crowded positioning as investors chase scarce areas of growth.
We do not expect the strong first-quarter performance of tech shares to be sustained, but see selected opportunities in the sector as disruptive innovations create growth opportunities.