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Q&A: How to approach the fast-moving tech sector

Our Blog Mar 13, 2017
Melda Mergen, Deputy Global Head of Equities

Investment opportunities in technology can appear almost endless. In this rapidly changing sector, investors should know how to separate hype from opportunity.

Equity investors are looking for growth, and technology is an exciting area to achieve just that.

The technology sector has been by far the biggest driver of the U.S. economy for over the past two decades. In 1995, less than 8% of S&P earnings came from tech, but by last year that number reached 21%. Only one technology company — Microsoft — cracked the top 10 largest S&P 500 companies by market capitalization in 1995. Last year there were five: Apple, Microsoft, Amazon, Facebook and Alphabet (Google). The culture of these big companies is one that encourages innovation, which means technological changes are happening at scale, in a way that wasn’t true a few decades ago.

Technology is entrenched in our daily lives. Its reach into other sectors is constantly growing. Media, communications, retail and financial services industries have been deeply affected already. In the future, we’ll see a more significant effect in transportation, manufacturing, agriculture, energy and life sciences, too.

I sat down with tech-obsessed, Silicon Valley expert Rahul Narang, senior portfolio manager, to sort out what investors need to know.

Melda: Where are opportunities in tech headed?

Rahul: While most of the industry’s prominent tech companies are American, technology trends are global in nature as there are some powerhouses outside the U.S., too. Look at South Korea’s Samsung Electronics and the Chinese e-commerce giant Alibaba. There is plenty of room left to grow around the world. Globally, internet penetration is around 47%, while e-commerce only represents 9% of total retail sales. Recent surveys of chief information officers (CIOs) show optimism in tech spending, especially in Europe, where many CIOs say they have underinvested in tech over the past five years.

M: There’s a lot of competition in tech. How do you distinguish winners from losers?

R: The aim for investors should be to own stakes in great businesses — regardless of their market capitalization or geographic location. The strongest ones will have the potential to create new value and be disruptive.

A key feature of the most attractive technology companies is their strong "moat" characteristics. In other words, these are business models that are easier to defend against competition. The characteristics include high barriers to entry and scale, strong return on assets and equity, high switching costs, strong intellectual property, durable brands, pricing power and network effects.

M: What themes should investors focus on for the future?

R: It’s helpful to consider some broad, long-term themes for where technology may take us.

One area is artificial intelligence (AI). AI software governs everything from speech recognition to online searches to motion detection systems and intelligent assistants like Apple’s Siri and Amazon’s Echo. The key driver of AI adoption is enhanced computing power that can process unstructured data. In the medium term, AI can power voice and image recognition for things like fraud detection and medical diagnosis. In the longer term, it should make its way into self-driving cars, smart homes and smart cities.

Another related theme for the future is autonomous driving. Transportation is changing as self-driving vehicles prove their viability. Investment is pouring into this area — from traditional car companies like Ford and GM, from new arrivals like Tesla and even from tech giants like Google.

There are also interesting prospects for augmented reality (AR). This blends virtual reality and real life. Probably the best known example to date has been Pokémon Go, the first mass-adopted AR game. Plenty of other AR applications are out there. Microsoft’s HoloLens headset lets users see and interact with holograms overlaid across the physical environment. There's potential for AR technology to be widely used in other areas like engineering and financial trading environments — in the case of the latter, traders might view complex data as 3D images that could be drilled down into using hand gestures.

“The aim for investors should be to own stakes in great businesses — regardless of their market capitalization or geographic location. The strongest ones will have the potential to create new value and be disruptive.”

M: Any thoughts on the IPO market for technology stocks?

R: The IPO market is expected to pick up in 2017 after a lackluster 2016. The recent debut of Snap Inc. on the NYSE shows that the market is reinvigorated, so there will be more companies entering the market in the coming months. Through December 2016, roughly $3.3 billion had been raised according to Bloomberg. This compares with $8.3 billion in 2015 and $35.4 billion the year before when Alibaba went public.

M: What’s the role of tech in a rising rate environment?

R: Technology sector outperformance is largely due to cyclical sectors being better positioned than defensive sectors when interest rates rise. The thinking is that inflation and rising rates often foreshadow or follow stronger economic growth, which may boost investment on projects, property or equipment, and serve as a tailwind for cyclical sectors like tech, industrials and energy. This same tailwind acts as a headwind in defensive and bond-like sectors — health care, consumer staples — which are not as sensitive to a pickup in economic growth.

Technology companies also have healthier balance sheets than other debt-laden firms and sectors, making them less vulnerable to rising rates. Cash balances allow tech companies to pursue shareholder-friendly policies of buybacks, dividends and M&A activity.

M: With tech comes hype. How can investors stay vigilant?

R: Right, things don’t always turn out as expected, and the tech sector is more susceptible to hype and bubbles than most. We saw that the excitement around 3D printing and wearable technology was overblown.

But long-term investment themes can benefit investors over the long haul, if they align themselves with companies that are positioned to take advantage of trends as they unfold.

Bottom line

It’s important to maintain balance and look for the most sustainable characteristics in a business. The pace of technological innovation and disruption is accelerating; disruptive business models are emerging all the time, and the outlook for the sector is as robust as ever. Given how exciting these new themes are, it is important that investors be aware that mature technologies can present themselves as overlooked opportunities as many of these legacy firms will remain critical to the overall technology infrastructure and ecosystem. In such a fast-moving environment, investors need to focus on the strongest attributes and the most promising long-term themes.

 

Melda Mergen

Melda Mergen

Deputy Global Head of Equities