Are tech stocks worth their lofty valuations?

A combination of low interest rates and pandemic conditions has resulted in a rapid acceleration in valuations in the technology sector

Although technology stocks have lofty valuations, with some trading at 30-times their revenues, the sector has the potential for a return to superior earnings growth, says Janus Henderson's Rechard Croce. Getty ImagesShow less

Entering this year, we fully expected that strong secular technology growth themes such as payment digitisation, internet transformation (everything available on demand) and next generation infrastructure, would continue to gain traction.

However, we would not have predicted the significant acceleration of these trends in 2020. The digital transformation of our lives was mandated by the measures put in place to tackle Covid-19, at the same time when central banks and governments unleashed funding and policy support at levels unseen since the 2008 global financial crisis.

As the chief executive of online education provider Chegg said: “…a crisis often accelerates the inevitable…”.

We see strong evidence that the convergence of long-term growth themes is driving an even broader set of opportunities for investors within technology.

As commerce increasingly moves online, social media platforms are establishing their roles as shopping malls – developing social commerce patterns that we have seen emerge in China. This is driving demand for payment digitisation as small and medium-sized businesses, governments and consumers seek more efficient transactions and peer-to-peer transfers.

The ease of transacting online is broadening the spectrum of the internet transformation theme to areas such as education, e-sports, primary healthcare, pharmacy and groceries, which have moved from nascent to early stages of adoption.

As vaccines are rolled out, societies will revert to ‘a new normal’, where we will inevitably rely more on technology, have more flexibility for workers, more convenience for families, more efficiency for businesses, more accessibility for students and be kinder to the environment.

We believe companies that stand to benefit from the rising and broadening adoption of technology by consumers and businesses will require an acceleration of investment to ensure scalable, seamless, fast and reliable connectivity.

Investment in next generation infrastructure, such as 5G, cloud, edge computing and the associated silicon (used in microchips, transistors, electronic circuits etc), could be further boosted by fiscal policy to create a greener and more inclusive economy.

Our conviction and enthusiasm for the growth prospects of the tech sector remain high, but we recognise that a combination of low interest rates and pandemic conditions has resulted in a rapid acceleration in valuations in some segments such as high growth software and certain commerce-related areas.

The technology sector relative to broader global equities currently appears attractive given the strong growth profile and balance sheets of many tech companies.

Also, the bifurcation in valuations in the technology sector is extreme by historical standards and reflects in part the increasing diversity within the sector.

However, it also indicates that there are pockets of hype (some stocks trading more than 30 times’ forecast revenues), which warrant caution and requires experience in stock selection and a disciplined valuation-aware approach.

Bargain or bubble?

Given the consistent outperformance of the technology sector versus the broader equities market over the past 20 years, the fact that high relative valuations remain within historical ranges often comes as a surprise to investors.

This sustained outperformance can be attributed to the superior earnings growth that the technology sector has achieved compared to other sectors, which we believe has the potential to be sustainable over the long term.

Earnings for the technology sector grew last year – one of only three sectors to do so (utilities and consumer staples being the others).

While we expect that the earnings recovery in the broader market may be faster in 2021, simply due to comparisons with 2020, the tech sector has the potential for a return to superior earnings growth.

This reflects the sector’s record of exceptional financial strength and having the highest propensity to reinvest for growth through research and development.

We believe that the long-term drivers of technology share gains – demographics and a host of powerful long-term growth themes are even more relevant in a post-pandemic world. While pockets of hype in the sector temper our enthusiasm, overall, we have optimism for a recovering global economy and a political backdrop that will continue to be favourable for technology equities but where valuation discipline will be required.

Richard Clode is a portfolio manager at Janus Henderson Investors, a member of The Gulf Bond and Sukuk Association