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November 2017

Tech sector: same but different

Technology stocks are booming again. But that doesn't mean that we are due a repeat of the dot-com bust.

Boom, bust... and boom again. Global technology stocks have surged over 40 per cent this year alone, and are now worth 56 per cent more than they were shortly before their infamous slump in 2000.[1]

Does that mean we are due another bust?

We don’t think so. Much as today’s technology – from partially autonomous vehicles to wifi-controlled fridges and washing machines or even robo-surgeons – looks very different from the tech available some 20 years ago, so do IT companies’ profit and loss accounts. Back then, the Internet sector’s net contribution to the overall operating income of MSCI World stocks was roughly zero. Today, it contributes between 6 and 7 per cent.[2]

That’s not the only favourable comparison with the bubble-era.  Tech firms today are no longer valued solely on a per subscriber basis, but also on more traditional metrics such as revenues. At the same time, their subscribers are now bringing in vastly more money as billions of us use mobile devices.

Price-to-earnings ratios are a testament to this evolution. True, the global technology sector’s P/E multiple of 21 times is a little pricier than that of the overall market. But it is hardly in bubble territory, especially when compared with the ratio of 67 times seen before the dot-com bubble.[3]

tech sector leads on earnings growth
Earnings growth: MSCI World IT Index versus MSCI World Index, % since 1995
technological boom

Source: Thomson Reuters Datastream, as at 31.10.2017

With the third quarter reporting season already underway, information technology companies are forecast to deliver 23.5 per cent year-on-year earnings growth – the second highest of any S and P 500 sector.[4]

The outlook for future profits also remains positive: justifiably, analysts continue to upgrade their tech forecasts.

And in another departure from the dizzy euphoria of the previous dot-com mania, cash has become king. In the US, all of the top five most cash-rich companies are in the technology sector, which in 2016 generated 48 per cent of total non-financial free cash flow.[5]

The dramatic improvement in the tech sector's standing reflects how quickly the world is progressing on the path to digitalisation. Already, some 3.7 billion of us are online and that is forecast to surge to 4.6 billion by 2021, covering more than half of the world’s population.[6] The AI market alone is forecast to grow to USD127 billion by 2025 from just USD2 billion in 2015.[7]

All this provides ample opportunities for well-positioned companies to grow and prosper.

The art of picking the winners

That's not to say investors can be complacent. New technologies can take a long time to develop and commercialise, and there is a risk of investing too soon.

Quantum computing is one such example. In time, the technology promises to make computers faster and smarter by capitalising on the ability of subatomic particles to exist in more than one state at a time. However, we think we are unlikely to see a commercial quantum processor or computer for at least another five years – many early innovators may fall by the wayside before the technology becomes established.

Autonomous vehicles, on the other hand, are already partly a reality through the inclusion of various aspects of advanced driver assistance (ADAS) technologies in the latest car models. Fully driverless cars, lorries and buses, however, are still some years away from being developed – and then likely a few more years from becoming viable for the mass market.

Another concern is the rise of the tech pretender. 

Today, virtually every company wants to be seen as keeping up with the tech revolution in some shape or form. The reality, however, is that only a relatively small number actually make a sizeable share of their money from latest innovations. Regulation is a red flag, too. The heavy dominance of the top tech players in the market increases the potential for more stringent regulations to foster competition and protect consumers.

Undoubtedly, the tech trade has become more crowded following hefty investment inflows into tech-related funds. But the opportunity pool is also growing, with emerging market companies increasingly joining the tech world. Indeed, tech is now the biggest sector in EM, accounting for 27.6 per cent of the MSCI Emerging Markets Index today from around 10 per cent a decade ago.[6]

So, as long as price appreciation goes hand-in-hand with higher earnings, then we believe tech is going in the right direction. Of course, there will be the inevitable bouts of profit taking or market corrections, such as the one seen in 2016. But for long-term investors who are willing and able to sit out any volatility, we believe the future is bright.