Despite heightened market volatility at the start of 2022 and pressure on technology stocks in particular, we believe the sector’s fundamentals look strong. In this update, we provide our thoughts on recent market conditions, summarize our top takeaways from the latest earnings season and discuss where we see significant potential opportunities going forward.
After reaching an all-time high in December, the tech sector has experienced a tumultuous start to 2022. January’s sharp correction saw steep declines across the market cap spectrum, with high-growth names and small-cap stocks suffering the most. The downward moves can partly be attributed to the macro environment; specifically, inflation concerns and The Fed’s move to a more hawkish stance (the market is now pricing in five rate hikes this year). There is also some apprehension among investors on the future prospects of Covid beneficiaries as the world reopens and nervousness around Q1 earnings (a traditionally slower season for the tech sector). In our view, such concerns are overdone. We remain bullish on software and semiconductor names in particular and believe recent downward moves have opened up attractive entry points among companies with solid fundamentals. Ultimately, this is an intriguing market for active stock pickers.
Our approach involves making incremental, measured adjustments in order to keep a balanced portfolio over time. Prior to January, Q4 2021 saw us lock in gains on select outperforming disruptors—rapidly growing companies challenging traditional business models. At that point, we moved capital into compounders (firms growing consistently and predictably) and evolvers (what we call mature businesses with durable revenue streams that are adapting to technological disruption). That reversed somewhat in January due to market conditions, and we are once again finding opportunities among high growth disruptors where we see solid fundamentals, attractive valuations and tremendous growth runways going forward.
Over the past decade, tech drawdowns have been driven by either fundamental downswings, monetary policy shifts or regulation. The biggest risk at present, in our view, would be a deterioration of fundamentals, but that’s not what we’re seeing, nor is it what we expect. On the contrary, fundamentals look strong. From a macro perspective, provided rates don’t reach levels seen in the 1980s, we believe the tech sector can cope well. It is worth noting that tech stocks historically tend to underperform ahead of rate rises but actually begin to outperform as rate rises take effect. The current environment could therefore present a buying opportunity. Aside from market moves, we may see a more subdued IPO market in 2022 following the strongest year for IPO listings and volumes in history. Management teams could opt to delay listing plans until the market has recovered and volatility subsides, although it is likely that a healthy level of strategic M&A among tech companies will occur.
In the software space, on average, we’ve seen impressive earnings. In particular, firms enabling the shift towards cloud computing are seeing remarkable growth which, in many cases, we believe will continue through 2022. In the internet advertising space, the results have been mixed. Companies that have adapted well to changes in privacy laws by launching innovative ad products and optimising business models through new technology appear to be in a strong position. Those slower to change are experiencing challenges. As advertising dollars continue to move online, we believe true innovators to emerge as the winners. On the subject of inflation, companies note that supply bottlenecks are continuing, although there have been improvements on the logistics side (ports reopening, fleets returning to capacity). Rising wage costs are a big risk, but, encouragingly, we see firms stepping up efforts to boost labor productivity.
The disruptive, high-growth segment of the market bore the brunt of January’s selloff, but we believe select names now look attractive in valuation terms, particularly in the mid-cap space, and fundamentals remain solid. We’ve also seen some Covid beneficiaries position themselves as long-term winners with durable business models instead of merely key software suppliers in a time of crisis. The pandemic accelerated many secular growth trends, and the demand for digital transformation services was certainly one of them. Elsewhere, the ascendancy of electric vehicles (EVs) is fuelling demand for chips and creating what we consider to be a captivating EV supply chain growth story for the semiconductor industry. Fintech is another area of interest, particularly innovators in the business-to-business (B2B) payments space. Meanwhile, the risk of cyber security threats is leading companies to pay for high-quality software and IT solutions. More broadly, innovation has become democratised due to the rise of the cloud and connected devices, and we increasingly find examples of innovative companies in the mid-cap space—not just in the US, but also in emerging markets. We continue to believe there is a disconnect between where investors are positioned in technology companies today and where we see the best potential investment opportunities over the next decade.