Investing in the future with technology

Sector overview

The Covid-19 pandemic has spurred adoption of new modes of work within businesses. Already prevalent across industries, technological advancements have been further accelerated. Changes in structural trends including automation, remote working and learning, and e-commerce have become a major focus for companies and investors. In addition, shifting consumer demand dynamics arising from the pandemic has driven behaviour changes, work-from-home arrangements, and supply chain localization. Meanwhile, the 5G rollout underscores persistent demand for semiconductors, global information technology (IT) spending continues to rise, and cloud adoption remains in its infancy. The global technology sector has displayed relative resilience during the market volatility in the first half of this year. Even prior to the Covid-19 sell off in late February, tech had been the market leader for several years thanks to unmatched earnings growth and an increasingly strong secular outlook. The structural developments highlighted have been augmented amid the pandemic and have penetrated all sectors. This means standard equity benchmarks are also evolving as these trends continue to shape the way businesses are done. Factoring in long-term technological growth will be key when making investment decisions.

Growth companies with a quality tilt

We believe that low levels of leverage and high levels of cash as a percentage of total assets give technology companies a higher quality tilt than in previous decades. Despite the demand shock, tech stocks look favourable with cash rich balance sheets and the lowest net debt/EBITDA across sectors.1 Corporate cash flow needs (ex-tech) could lead to a pullback in capital expenditures; however, many corporates are likely to find IT CAPEX both a cost saving and growth opportunity, particularly among mature cloud computing platforms.

Technology stocks have been top contributors to broad market indices since the February market peak

Technology stocks have been top contributors to broad market indices since the February market peak

Source: BlackRock, Feb 17 220 to Aug 21 2020.

Technology stocks tend to overweight the momentum factor and are positioned for growth in this climate, with structural tailwinds being the primary driver. Traditional, cyclical patterns may not have as great an impact. The sector has been the top contributor of returns in S&P 500, MSCI Emerging Markets, and S&P Global 100 indices2. We have seen tech earnings unscathed by Covid-19 – in the S&P 500, only technology (+3.9%) and health care (+3.1%) reported year-on-year growth in Q2 revenues. Tech is also one of three sectors seeing positive earnings growth in the quarter (+2.7%) while the broad market gauge is expected to decrease 33.7% from a year ago.3 FAANG stocks alone saw an average of 69% Q2 earnings growth year-on-year, versus -0.3% for S&P 500 and -0.39% for ASX 200.

Indexed to MSCI

EPS Growth of FAANG stocks vs. Broad Market Indices

EPS Growth of FAANG stocks vs. Broad Market Indices

Source: BlackRock, Feb 17 220 to Aug 21 2020.

Drivers of change and disruption

As companies become compelled to re-define their industry positioning due to structural changes, internet and mobile technologies have been at the forefront of the discussion and the backbone of the proliferation of innovative business models. To put this into context, global IT spending estimates at the start of this year suggested that cloud investments, with a public penetration rate of only 10%, will lead the software sector to be the fastest growing in 20204. The impact from the pandemic will likely accelerate this trend as businesses adapt to the importance of an online presence, sharpening the need for best-in-class network infrastructure and data analytics, as well as a demand wave for ancillary tech products. Meanwhile, advances in 5G, robotics, artificial intelligence (AI), data storage and analytics, the internet-of-things, digital payments, and cyber security represent significant tailwinds that should drive demand across semiconductors, hardware, and software.

We see these advances becoming increasingly vital core competencies across sectors. Internet retail businesses including Amazon, Ebay, Alibaba, and Meituan Dianping have evolved the e-commerce landscape, from warehouse mobile robots to drone delivery to group buying, all of which aim to enhance the consumer experience. Biopharma companies such as Regeneron and Celltrion have embraced AI and machine learning to improve predictive analytics for patient conditions while cutting costs. Manufacturers use data analytics to improve procurement and pricing. Banks such as Goldman Sachs and Citigroup are pouring capital into blockchain technology to streamline operations. Translating these observations into portfolios, traditional equity exposures are evolving beyond their official sector classifications. New economy developments will be central to driving returns as we invest into the broad market*.

Looking ahead: election and policy risks

Regulatory headlines may drive performance of key technology stocks as we head towards the U.S. presidential election in November. The outcome may influence the direction of statutory corporate tax rates, which was lowered from 35% to 21% under the Trump administration, while Biden has supported raising the rate to 28%. The U.S. is also due to implement a federal data privacy law.

Bottom line

We believe the role of new technologies has been augmented across industries amid the Covid-19 pandemic. While tech stocks have been the top contributor of returns to standard equity exposures, these broad market indices will continue to evolve as new economy business models develop across sectors, making technology a persistent theme to be considered when making investment decisions.

*The specific issuers/securities discussed are for purposes of explaining the investment strategy, and should not be construed as research, investment advice or a recommendation, or an offer or solicitation to buy or sell any securities or to adopt any investment strategy.