The gravity-defying rally in technology shares has led some commentators to draw comparisons with the dot.com bubble of the late 1990s. However, Mikhail Zverev and Alistair Way believe there are still opportunities to be found in some of the sector’s less-fashionable stocks.
The economic damage created by the COVID-19 pandemic is extensive and much of it permanent. The International Monetary Fund in June predicted global output would suffer its biggest annual contraction in living memory in 2020.1 That has led to a record number of companies, spanning several economic sectors, going bankrupt.
It may seem strange then that global stock markets are currently hovering close to record highs. That they are is largely explained by a stunning recovery in the shares of leading technology companies, especially those in the US and China. On August 19, Apple became the first two trillion-dollar company, just two years after its market capitalisation reached $1 trillion. By mid-October, the Nasdaq composite was up 30 per cent for the calendar year. China’s equivalent, the ChiNext, has fared even better. Scarcely believably, it has advanced 50 per cent since the turn of the year.2
The power of three
Mikhail Zverev, Aviva Investors’ head of global equities, says the simultaneous confluence of three factors lies behind the rally in technology shares. The first is the collapse in global interest rates. According to discounted cash flow valuation models, all share prices should be boosted by falling interest rates. But technology shares are especially sensitive, as in many cases companies are not expected to generate and pay out cash long into the future. Those pay-outs have suddenly become a lot more valuable.
“Theoretically, you could argue much of the outperformance of growth stocks is a duration trade in disguise,” he says.
Investors have been desperate to snap up shares in an increasingly rare band of companies capable of delivering capital growth
Secondly, against the current depressed economic backdrop, and with interest rates incapable of going much lower, investors have been desperate to snap up shares in an increasingly rare band of companies capable of delivering capital growth. Whereas most firms have been hobbled by the pandemic, many technology companies are benefitting from it as growing numbers work, study and shop from home.
Thirdly, these two factors have together encouraged a surfeit of momentum trades as the fear of missing out on the rally causes many investors to ignore fundamental valuation considerations.
The surge in technology shares has inevitably drawn comparisons with the dot.com bubble of the late 1990s, with no shortage of commentators warning the rally is unsustainable. However, Zverev says most investors appear to believe otherwise. That is partly because, unlike in 1999, many of the companies leading the advance such as Apple, Alphabet, Facebook, and Microsoft are highly profitable. This is helping deter would-be short sellers.
A polarised market
It can be argued that the rates of earnings growth being priced into many technology shares is unrealistic and investors in these companies are ultimately likely to be disappointed. However, Zverev and Alistair Way, head of emerging market equities at Aviva Investors, argue that as with broader stock indices, the headlines made by the technology sector are masking significant polarisation within it. While they believe investors would be wise to give some technology shares a wide berth, there are others that have barely participated in the rally and are more reasonably valued.
There seems little doubt some of the structural changes taking place in economies, such as the growing importance of data and analytics, and with it cloud computing; the development of fifth-generation mobile phone networks; and advances in artificial intelligence, to name but a few, have the potential to drive sizeable profits for many companies. However, while stock markets are prepared to attach extremely high valuations to the shares of some companies set to benefit from these shifts, in other instances that is not happening.
Developed markets are drawing a clear distinction between software and services companies and makers of semiconductors and hardware equipment
Zverev believes developed markets are drawing a clear distinction between software and services companies and makers of semiconductors and hardware equipment, attaching extremely high valuations to the former but not the latter.
“For businesses that are capital light, with recurring revenues and predictable growth, no multiple is high enough. Semiconductor and hardware businesses, by contrast, are viewed as risky and cyclical,” he says.
Take Apple shares. In recent years the company has managed to convince investors it is as much a services company as it is a hardware manufacturer, even though its services arm is a small part of the overall business. As a result, the market expects future earnings will not only grow faster but is prepared to attach a higher multiple to those earnings. Apple shares are currently valued at 32 times forward earnings, up from just 12 times two years ago.3
Zverev is cautious on pure software services companies, especially those that are not yet profitable. He cites Snowflake, a US company that enables companies to warehouse databases on the cloud more efficiently and securely, as an example of a company to be cautious on. Shares in Snowflake, which has yet to make a profit, are trading at 89 times revenues.4
“Such a high valuation may turn out to be justified. But even though the transition to the cloud is a change I believe in, there seem better ways to play this trend,” he says.
After all, memory chips and optical communication components will be needed to make the software run. Yet the shares of the leading maker of optical components are trading at 13 times next year’s earnings.5 As for the chipmakers that make the memory chips that store the data, they are often priced below the replacement cost of their building, land and equipment.
Chinese investors on the hunt for national champions
Emerging equity markets are equally polarised. However, the division is less between technology hardware and software and services companies’ shares and more between the Chinese market and the rest. Way believes some of this is explained by the worsening technology cold war between the US and China. That is causing Chinese retail investors to bid up the price of what they perceive to be national champions.
The divergence in valuations between Chinese tech hardware stocks and Korean or Taiwanese rivals is very big and hard to justify
“The divergence in valuations between Chinese tech hardware stocks and Korean or Taiwanese rivals is very big and hard to justify. In several cases, we’re seeing exorbitant valuations attached to what remain mediocre companies,” he says.
Way points to the example of Semiconductor Manufacturing International Corporation (SMIC), a partially state-owned publicly-listed Chinese semiconductor foundry company, the largest in mainland China.
“It’s a company with legacy technology; it is not closing the gap on international rivals; its operational performance is not great; virtually all its profits come from government subsidies. That hasn’t stopped Chinese retail investors piling in,” Way says.
SMIC shares have virtually doubled this year as investors bet the US government’s efforts to prevent Chinese telecoms giant Huawei from accessing the latest chip technology will lead to Beijing ploughing money into the company to help it catch up with the likes of Taiwan Semiconductor Manufacturing Company, the world’s largest contract chipmaker.
Smartphone maker Xiaomi is another example of a Chinese company whose share price seems hard to reconcile relative to more lowly-rated international peers. Its shares trade on a multiple of around 30 times forecast earnings. By comparison, shares of its South Korean rival Samsung Electronics trade on less than 16.6
“It (Xiaomi) has a good brand. I think its phones are every bit as good as Samsung’s. But the market is valuing it more like a conceptual tech stock. To attach such a speculative multiple to the shares is inexplicable. The global smartphone market is littered with failed brands and failed concepts,” Way says.
Taiwanese and South Korean companies should be less vulnerable to a ratcheting up of tensions between the US and China
As a result, when it comes to investing in technology hardware companies, he is looking elsewhere other than China. The fact Taiwanese and South Korean companies should be less vulnerable to a ratcheting up of tensions between the US and China, makes their comparatively low valuation all the more attractive.
Valuations no longer quite so important
That said, Way argues that in the current environment valuations are less of a consideration than they ordinarily would be. Instead, correctly anticipating changes in the environment in which companies operate is more important.
For example, while the valuations of some Chinese internet companies at first glance may look extremely high, the shift in economic activity from offline to online brought about by the pandemic is likely to be a trend that is here to stay. Way sees huge growth potential for online grocery sales. After all, for a country where a large percentage of retail sales are conducted online, penetration of supermarkets is surprisingly low at just two per cent.
“We’ve been prepared to pay what look on the surface to be high multiples to get exposure to a trend we believe could disrupt the sector significantly. Getting the right company is more important than buying a cheap company,” he explains.
There are several darkening clouds on the horizon; prominent among them is the threat of a much tougher regulatory environment facing big tech companies
While the tailwinds that have been propelling some technology shares higher may be set to continue, valuations are now looking stretched in many areas. After all, there are several darkening clouds on the horizon too. Prominent among them is the threat of a much tougher regulatory environment facing big tech companies, potentially impairing the ability of the likes of Facebook and Google to acquire a disruptive competitor and stifle competition.
The extent to which growth and momentum factors have driven this year’s rally in equity markets has proved challenging for Zverev and Way given their investment process deliberately chooses to avoid this kind of ‘style bias’. Zverev says that in the last 18 months or so, and for the first time in his career, it has become hard not to own the likes of Apple even if you do not have an angle or are negative on it.
“Even in a global benchmark, you’re suddenly talking about five per cent of the index. This has led to many investors being pushed into behaviours that do not reflect their stock-specific conviction,” he says.
Given that, both he and Way argue it is more important than ever to maintain a disciplined investment approach.
“Being a benchmark-agnostic investor has become much harder,” acknowledges Way. “But it’s potentially a much more important job in the long run. These are the circumstances where it should really pay to make the right decision; whether to go with the crowd or stand firm and not get sucked in.”