Mega-cap tech as a long-term exposure

Key takeaways

• Year-to-date, technology has outperformed the broader market largely given the prevalence of low leverage, high profitability and consistent earnings across many names in the mega-cap tech space.
• Technology serving as a source of quality in periods of market volatility is a distinct change to the late 1990’s where the sector was the source of the volatility.
• This change is driven by large-cap companies being more mature, less volatile, with an ability to generate consistent profitability. These quality characteristics may continue to be in demand by investors in an environment of decelerating economic growth.

Equities have officially entered a correction. Both global and domestic stocks have fallen by at least 10% below their summer peak. Volatile portions of the market, notably small cap and early growth companies are down far more. And while large-cap technology companies have not been immune to the weakness, for the most part they have held up better than the broader market. I think this can continue as investors put a premium on higher quality, companies with the ability to generate cash-flow.

Since the summer peak, the global technology sector has outperformed and remains the top performer year-to-date (see Chart 1). Tech’s resilience owes much to the fact that the mega-cap tech names tend to have low leverage, high profitability, and consistent earnings. In other words, they are high quality companies.

Global sector performance - year to date

What investors Want

For investors old enough to remember the late 1990’s, the idea of technology being a source of quality during periods of market volatility seems odd. These were the stocks that led the market bubble on the way up and were punished the most when the bubble finally burst in 2000. What has changed? The simple answer is the companies in this sector are more mature, less volatile, and more profitable.

One important reason that large-cap technology stocks have held up, despite the surge higher in interest rates: these companies generate strong cash flow. Contrast this with their younger, early-growth cousins. Early growth companies are down roughly 30% from the July peak. The backup in interest rates has been particularly punishing for these companies because their cash-flow is in the distant future. Put differently, a higher discount rate has a more negative impact on early growth companies than those with significant near-term cash flow.

The fact that these companies are more mature and more profitable, also means that, unlike the 1990’s, many of the mega-cap tech companies trade close to a beta of one. In other words, they generally trade with no more volatility than the broader market. This is important because in the current environment investors are demonstrating a clear preference for lower beta companies and an aversion to excess volatility.

The other distinguishing characteristic of these companies: The large, ‘platform’ companies have strong entrenched user bases and consistent demand. And with interest rates high and the economy likely to slow from here, consistency is becoming more important to investors.

Large Cap Tech = High Quality

Tech outperformance looks less strange viewed through a factor perspective. While the market can rally into year-end, investors are likely to prove more risk averse than they were earlier in the year. Higher rates, tighter financial conditions and the prospect for an economic slowdown have left investors with a clear preference for safety and an aversion to volatility. Our view is that mega-cap tech names can offer these quality characteristics. They can be highly profitable and, perhaps somewhat surprisingly, reliable.

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