Where next for technology stocks?

The technology sector has had a rough six months, with stocks that have only fallen 30 per cent seen as having fared well. A long overdue and well-deserved sector shake-out, or yet another market overreaction that has gone too far?  

 

Not a rerun of the dotcom bust

There will be understandable concerns that the current slump will turn into a rerun of the much more severe and widespread collapse seen after the sector peaked following the dotcom boom in September 2000. Then, the sector dropped by 95 per cent over 18 months, with numerous business failures. 

Too many companies then were based on hopes and dreams of what a tech future might offer, but the world was neither ready nor capable of changing and many of the companies still had largely unproven business models. Things are different today:

  • Devices and networks are significantly faster – the fastest mainstream internet speed in 2000 was around 1mbit/sec; today in the UK it is 900mbit/sec.
  • Mobile data moved at a top speed of 115kbits against 5G’s top speed of 3,000mbits (25,000 times faster).
  • Businesses have proved the speed, convenience and cost advantages available from the transition to cloud services.

Also, at that time, many of the technologies that are now reshaping our world had not been invented: Android (2003); Facebook (2005); Youtube (2005); Twitter (2006); AWS (2006); Spotify (2006); iPhone (2007). These driver businesses, plus numerous others, have well over a decade of proven delivery behind them. 

Furthermore, many think the 2000-03 slump largely hit telecommunications and hardware rather than software companies, and the market still carries the scars of this: the hardware and telecommunications sectors today feel like bit-part players. Cisco’s (US:CSCO) share price, for example, is still one-third below its 2000 peak; Amazon’s (US:AMZN) share price by contrast is 48 times higher and Microsoft’s is five times higher. So it could feel as though history is going to repeat itself, with an explosion of disappointment or businesses failing to deliver but, thus far, that is not the case. The tech sector’s slide today is more technical. 

 

Why has the sector slumped?

There are a number of key reasons why the technology sector has fallen back so sharply in the past few months. 

Interest rates – why would interest rates impact a sector that has no debt (many companies have huge cash balances)? The interest rates here are ‘discount rates’ used in discounted cash flow (DCF) analysis (see later) to value technology businesses. These rates are a function of risk-free returns (RFR) (usually sovereign debt yields), actual debt costs and risk. RFRs and perceived risk in particular have been rising.

Inflation – software and services companies have large staff costs and wage growth has been running hot for over a year. Double-digit increases are common and in specialist areas as high as 25 per cent. Most businesses are trying to pass this through in higher prices, but there is understandable doubt about clients’ ability or willingness to pay. 

Exhaustion – no sector can rise for ever and eventually investor exhaustion develops. Fans will lose faith, gains will be harvested and equity valuations will simply look too high and too stretched relative to growth, absolute profits and other sectors. This leads to:

Rotation – investors buy other sectors or configurations (deep value, recovery, cyclicals, defensives etc). The weight of money exiting a sector creates and then accelerates the absolute decline; the weight of money entering other sectors accelerates their share price growth, worsening the tech sector’s relative performance. 

There have been few warnings or negative updates from companies, thus far at least, and confidence in tech stocks’ high rates of growth remains intact. However, just because the sector slump is largely technical doesn’t mean that an early or sharp recovery should be expected. 

 

How technology stocks are valued

The main mechanism to value technology companies is, as above, using DCF. While overexuberant use of this method was largely responsible for overvaluations back in 2000, it now has the benefit of 20 years plus of proven business models, growth rates, margins and cash flow. DCF is a riskier tool than price/earnings (PE) or enterprise value (EV)/Ebitda as these only look two to three years ahead; DCF might model 10 years out and have the bulk of a stock’s worth in the ‘terminal value’ (what growth from year 11 to infinity is worth). Unlike earnings forecasts, DCFs have more moving parts (growth rates and all the elements that make up the discount rate or weighted average cost of capital (WACC) to arrive at today’s value of the income stream or cash flows) and more scope for material differences in value, most acutely in early-stage businesses. 

An initial but steadily dropping 40 per cent growth rate for a business might deliver a DCF equity value of 100 arbitrary units, while a 25 per cent growth rate gives an equity value of 49. Use a 20 per cent growth rate and raise the discount by 2 per cent, and the equity value is just 31. Thus the volatility we have seen recently.

 

The rule of 40

Technology investors also have a useful acid test to see whether a technology stock is good value – the ‘rule of 40’. Invented by US venture capitalists, it distils different aspects of performance into a single metric by taking the percentage growth rate and adding the free cash flow rate or the Ebit margin (not Ebitda – see below). If that sum is greater than 40, the investment should be good.

As an aside, it is important in this sector to choose the right metric to add to the growth rate. In many sectors, valuations use Ebitda (ie excluding goodwill amortisation) but in this sector this will overstate profits and flatter the equity value. A lot of tech stocks’ growth comes from acquired businesses and much of the acquisition cost will be goodwill (the difference between purchase price and ‘hard’ assets acquired). Not accounting for this and any capitalised development costs will make these businesses appear much more valuable than they actually are. 

A strength of the rule of 40 is that it allows businesses with very different profiles to rank positively, even those with either no growth or no profit/positive cash flow (see table 1). This metric should not necessarily be used to rank/compare stocks, as share prices and valuations can easily become misaligned, but the rule is a powerful first sift for potential investments. One might easily dismiss a lossmaker (the stock in the right column in table 1) but if growth is very high and gross margins are high (70-90 per cent is typical for software) such a business has a great chance of delivering fast-growing profits four to five years hence. 

 

Positive results from the rule of 40

Growth rate

0%

10%

22%

30%

40%

50%

Margin

42%

31%

18%

12%

1%

-10%

40 rule score

42

41

40

42

41

40

Source: Investors’ Chronicle

 

Should I still invest in tech?

Taking the usual long-term perspectives, yes. Making money from investments is about backing growth and technology businesses in all their guises are still some of the best prospects. There are other sorts of growth: recovery, cyclical, changed macro conditions (such as war) but these are more often temporary and these stocks are likely to revert to +/- gross domestic product (GDP) in fairly short order. Technology is one of the few areas in which one can expect to see growth sustained across extended periods and do so at rates well above underlying GDP. 

This is not likely to change as technology companies are delivering real, substantial and often disruptive change as the world undertakes a rolling programme of transitioning from local, manual processes to digital, cloud-based systems. This is happening now in more developed countries and more forward-thinking industries, but will sustain momentum as laggards progressively have to fall in line. 

In addition, technology companies (mostly) have business models that are extremely flexible and scalable – unlike, say, a UK-only clothing retailer that has a fairly finite market. A technology business in a field such as digital data and process transformation can work for companies and organisations in all horizontal and vertical markets, plus technologies (especially software) are capable of pushing sideways into totally new markets: Darktrace’s (DARK) marrying of artificial intelligence and cyber security is a prime example. The unbounded nature of technology businesses (although naturally some choose to limit the end markets they target) is a key reason for believing that growth and expansion can continue for extended periods, often ironing out the worst effects of the economic cycle. 

Also, this sector offers risk to suit all appetites. Nascent, complex, unproved technologies within businesses still heavily lossmaking and burning cash sit in the same space as businesses such as Microsoft (MSFT) or Sage (SGE) with very well-established and more readily understood business. Businesses of all sizes are available from market caps of tens of millions to the biggest companies in the world at more than $1tn (£767bn).

 

Stop looking for the perfect entry point

The phrase “trying to catch a falling knife” is often used when looking at a sector in sharp decline and trying to find the optimum time to buy in or back in; you risk a nasty wound if you get your timing wrong. The technology sector has fallen and, as growth rates do not appear to have been materially impacted, there has to be greater value available than before the slump. But that does not mean that further falls are impossible: as economist Keynes put it almost 100 years ago, “markets can stay irrational longer than you can remain solvent” plus equity markets more broadly face high geopolitical risk. On a long-term perspective, purchases made today are likely to make above-average returns in time, but may still lose ground in the near term. 

Picking a single entry point in terms of timing and stock amplifies the risk. A sensible approach to this sector is usually to drip-feed investment rather than target a lump sum and spread your investment by size, location, end market, risk profile and valuation. Buying a collective investment is an excellent way to manage risk and timing, and a raft of well-established trusts and open-ended investment companies (Oeics) are available, including Polar Capital Technology (PCT) and Scottish Mortgage Investment Trust (SMT). If looking to stick with individual stocks, it is best to take a portfolio approach. 

 

Some stocks to consider

Global giants. The US megaliths are still offering a lot of growth: Microsoft (16 per cent average next 3 years) and Amazon (42 per cent), both led by cloud services and software as a service (SaaS). While their respective PEs are 30 and 60, both should be nearer 20 by 2024. Zoom (US:ZM) has collapsed from trading at 60 times sales (overcooked) to just five times; its shares are just 17 per cent of their 2020 peak and this could be a take-out target. Crowdstrike (US:CRWD), a cyber security specialist, offers 35 per growth (a ‘40 Rule’ score of almost 50) in a market likely to see accelerating growth and has almost halved in price.

 

Amazon’s growth and equity rating

Year end

Ebit growth

EV/Ebit

2022

20%

49x

2023

57%

31x

2024

49%

21x

Source: FactSet

 

UK. Blancco (BLTG) involved in data sanitisation (fully wiping hard drives and solid-state memory) looks interesting from an ESG and GDPR standpoint, as well a growth. GB Group (GBG) operates in identity protection and offers double-digit growth in a potentially explosive market and Kainos (KNOS), a leader in the digital transformation of the UK public sector, promises double-digit growth with potentially very long horizons. 

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