In the past year, the technology sector underperformed due to the global equity sell-off. Significant outperformance between 2016-21 led to elevated valuations that couldn't be sustained in a higher interest rate environment.
Earnings estimates are falling due to poor economic growth, irregular demand, inventory management, and stronger supply chains. If there's good news, it's that expectations have been lowered. Despite these revisions and rising interest rates, stock performance in the third quarter (of 2022) was stronger than in the first-half.
Overall, we're positive about the tech sector. We're optimistic about the industry's innovation, deflationary impacts, and determination to digitize all enterprises. Corporate tech spending is strong and expected to remain so.
CEOs and CFOs are delaying larger transactions as they weigh costs and improve RoI. Foreign currency volatility, especially the strong dollar, weighs on industrial growth, while consumer spending on electronics declines.
As economies deteriorated and interest rates rose, the Covid-induced IT value boom faded. We see short-term risk to current values, but tech can keep its premium because it was undergoing a positive rerating before the pandemic.
Understanding subsectors
The technology sector is wide and diverse, with enterprises in many industries. Major subsectors' investment potential should be considered.
Semiconductors
The largest negative earnings revisions are coming from semiconductors. Various semiconductor titans cut third-quarter earnings forecasts by 10 per cent.
Semiconductors make up more than 20 per cent of the IT industry, and we believe this will be one of the finest long-term markets. We expect more opportunities to resolve these broad market concerns as consumer demand slows and inventories rebalance.
Reshoring manufacturing will benefit semi cap equipment makers strategically (three-five years). As smart and EVs become more common, we predict semiconductor demand to soar. Between 2022-28, the UAE EV sector is predicted to reach 30 per cent CAGR.
Software
At 30 per cent, software is tech's largest industry. Recurring and consistent cashflows have enhanced revenues, margins, and earnings while enhancing organizational predictability.
Furthermore, software companies tend not to be capital-intensive and have strong free cashflow margins. However, recent stock performance has been dismal, with software valuations plunging. Despite the subsector's strong free cashflow, interest rates limit prices. Strong growth, high-valuation companies have suffered the most.
Fintech and IT services
This group of stocks, which accounts for approximately 16 per cent of the total sector, is a mix of stable growing companies and disruptors seeking to capitalize on the shift to cashless transactions. Due to its consistent growth, this group used to trade at a higher relative valuation, but after a wave of consolidation, several of the companies have become deep value as free cashflow missed expectations.
The disruptors underperformed as post-pandemic reopening hampered ecommerce penetration. In the region, fintech continues to attract investor attention. The fintech business in MENA increased to $1.68 billion in H1-2022 compared to the previous year, making it the most-funded sector in emerging venture markets.
Hardware and communications equipment
This category accounts for 24 per cent of S&P 500 Tech. Apple dominates S&P500 Hardware & Equipment, accounting for 85 per cent. Valuations for the hardware section seem high, and negative revisions are likely for most consumer-facing companies, leaving us less optimistic about the outlook for this group.
The YUCs (young, unprofitable companies)
The most expensive, profitless technologies fared worst. YUCs have been more like an elevator than a rollercoaster, going in one direction and rising and falling swiftly. In early 2021, they had approximately 4.5 times the market return since before Covid began.
YUCs have trailed the S&P 500 since 2020 and produced modest absolute returns. While valuations have corrected, we believe the market will emphasize profitability. When financial conditions improve, this group may be ready to ride the elevator up.
Tech maintains its shine
Tech has de-rated substantially from historically high values as rising interest rates compress multiples across the board. The weakening global economy is affecting the more cyclical areas within tech, making the short-term treacherous.
However, we still believe that technology is a good medium- to long-term investment. As earnings projections fall, we urge investors to overlook short-term earnings adjustments and focus on the sector's growth prospects.
Investing thematically highlights fewer cyclical parts of the market. We believe cybersecurity remains an excellent area within technology for less cyclical growth. Data center investments and digitisation growth could slow slightly but the trends are here to stay. Meanwhile, events in Ukraine highlight the need for the manufacturing independence of key products within country borders, making re-shoring another key theme for tech investors.
