Tech Investing: Volatility, Valuations and Opportunities
By Jonathan Curtis, Research Analyst, Portfolio Manager, Franklin Equity Group
Markets have been exceptionally volatile since mid-November as investors digested the impacts of rising inflation, awaiting actions from the US Federal Reserve, the potential end of the COVID-19 crisis and the tragic situation in Ukraine. Rising interest rates have reduced what investors are willing to pay for growth and cash-in-the-future businesses, and may increase the risk of recession in the inflationary environment of rapidly rising prices fuel and food.
While rising rates reduce what investors are willing to pay for higher growth companies, they also generally indicate a strong or improving economic backdrop, which tends to be good for small and mid caps (mid caps ) more sensitive to the economy. businesses. Economic conditions look robust in the US and Europe, but inflation is also robust. As central banks raise rates to contain inflation, there is a risk that economic activity will falter and moderately dampen the short-term growth prospects of less diversified small and mid caps. Investors anticipated this, which led to a significant drop in stock market valuations.
In our strategy, we tend to focus on higher-growth small- and mid-cap companies, which are earlier in their path to profitability. These factors have been overlooked in recent months and, unfortunately, the blind sell-off has not, in our view, taken into account the strong fundamentals of individual companies.
We believe that well-capitalized, cash-consuming companies with strong unit economics (revenues and costs relative to an individual unit) and leadership positions in major secular growth markets can be excellent companies in any type of interest rate scenario. In volatile times like the one we are experiencing today, companies with these attributes can leverage their leadership position and easier access to capital to consolidate market share and outpace their capital-constrained peers. We are long-term, growth-oriented investors with quality at the center of our process. While we have seen higher quality companies with attractive long-term prospects – some with cash-hungry profiles – sell off, we have taken advantage of what we see as improved valuations to add to our positions.
Impact of the Russian-Ukrainian War on Europe and China
We pay close attention to where companies generate their revenue to understand their short-term and long-term prospects. Given Russia’s actions in Ukraine, we believe the risk of recession is rising in Europe, which makes us more cautious towards companies with higher European exposure. China’s increasingly strict and opaque regulatory regime has also prevented us from investing in the country. Conversely, we place greater confidence in companies with greater leverage in the US economy. We have also focused on higher growth emerging markets across Asia.
We anticipate a modest near-term impact on the production of semiconductors and technology hardware requiring nickel and titanium, as well as semiconductor-grade gases (neon, xenon, argon and krypton), which are partly sourced from ‘Ukraine. Importantly, our research indicates that there are large buffer stocks of these critical materials around the world, which we believe can last at least six to 12 months. Also, previous efforts have been made following Russia’s annexation of Crimea in 2014 to find new sources of neon (used in silicon chip lithography) outside of Ukraine. That said, as semiconductors are critical enablers of our digital lives, a prolonged supply disruption would likely present a revenue and/or cost headwind for the broader “digital transformation” opportunity. We believe the challenges would be more acute the closer a vendor gets to including semiconductors directly in their products.
Growing Sector Outlook
As long-term investors, we don’t strive to make short-term trading decisions at a sector or style level. The case for investing in technology companies is compelling, in our view, regardless of where we are in the business cycle. Businesses and consumers are investing in technology to improve their productivity. We believe companies are more willing to accelerate their investments in technology when they see their own prospects improving. The reverse is also true. Additionally, if headwinds from inflation persist in the labor market, we believe companies will look to improvements in technology and business processes to better manage costs. Such investments would be a tailwind for our “Digital Transformation” thesis, which could help offset the headwinds of the recession.
Longer term, we see significant opportunities in a range of themes, from artificial intelligence (AI), machine learning and analytics to new commerce and digital customer engagement, in ranging from cybersecurity, electrification, autonomous technology (enriching automated systems with sensors, AI and analytical capabilities), and more. While all of these opportunities are compelling, we believe the topic of secure cloud and SaaS (Software as a Service) represents the greatest opportunity as it underpins all other digitalization trends. None of the other themes are possible without the cloud. We are also excited about the transformation of digital media and the rise of the metaverse (a fully realized digital world). We believe that the metaverse opportunity may represent the ultimate application of “digital transformation”.
What are the risks ?
All investments involve risk, including possible loss of capital. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in fast-growing industries like the technology sector (which has historically been volatile) could lead to increased price fluctuation, especially in the short term, due to the rapid pace of change and product development and changes. in government regulation of businesses emphasizing scientific research or technological advancement or regulatory approval of new drugs and medical devices.
Past performance does not guarantee future results.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.