There is a growing consensus that the recent woes of some of the big US technology companies, together with concerns about greater government regulation, bodes ill for the sector. Talk of another ‘technology bubble’, similar to that of the late 1990s, is common. This undervalues the sector’s many attractions and the opportunities within the smaller company space. As such, the portfolios have been increasing their exposure of late. We should be rightly cautious of the cliché ‘it’s different this time’, but it may prove the exception for those portfolios taking the long view regarding this sector.
The major technology companies globally have had a phenomenal run in recent years. By way of illustration, the combined market capitalisation of the FAANGs (Facebook, Amazon, Apple, Netflix and Google) is now larger than the UK’s annual gross domestic product (GDP). The combined value of the FAANGs plus Microsoft and China’s Alibaba and Tencent now equates to Japan, the world’s third-largest economy. Underweight investors would have struggled to outperform, despite all the talk of ‘value’ as an investment concept making a comeback.
However, storm clouds have been gathering and the sector has seen a wobble. The markets have shown concern about some companies’ high multiples relative to their outlook, the recent lapses by Facebook regarding personal information and talk of increased government regulation in response to growing anger about monopolistic excesses. These companies should also be paying their fair share in tax to help fund essential services.
Although these issues are valid, they risk missing the bigger picture and the opportunities that lie within. Recent news has been reassuring. Alphabet (US:GOOGL), the owner of Google, has reported a 20 per cent rise in first-quarter (Q1) earnings. Netflix (US:NFLX) also announced good Q1 figures, adding another 7m subscribers, while Amazon (US:AMZN) has now surpassed 100m Prime subscribers. For now at least, the wobble has past. However, it is the sector’s long-term growth potential that offers the greater rewards.
Speaking recently with Katie Potts (Herald Investment Trust) and Walter Price (Allianz Technology Trust), both agree technology is now benefiting, at least in part, from its own economic cycle. The growth is coming from the creation of new markets, rather than simply growth in GDP – reflecting the sector’s ability to increasingly ‘disrupt’ established practices, courtesy of strong innovation and even stronger cash flows. As such, technology’s outlook is better than it has been for some time – being the common factor enabling a remarkable pace of change affecting almost every aspect of our lives.
The large ‘pure technology’ companies are looking to conquer new industries and opportunities. Both Google and Apple (US:AAPL) are investing heavily in financial services, Amazon is planning a bank account, both Apple and Amazon are eyeing the healthcare market, while voice-recognition technology offers numerous possibilities – Amazon already being able to offer its own-label range of household goods. Such disruptive practices will challenge the dominance of some household names.
Meanwhile, other technology companies operating in the traditional telecommunications, media and technology (TMT) space are helping other more diverse industries lower their costs, improve productivity and create new markets. Businesses across numerous industries are now embracing technology in an innovative way to help gain a competitive advantage – sometimes blurring what constitutes a technology stock. And this trend is exacerbated by business confidence being better than it has been since the financial crisis – consumers are spending, projects are being funded, equipment is being upgraded.
Media focus on the FAANGs would suggest the best way to access the sector is via the largest companies – but this would be wrong. While these companies possess certain advantages, including being the greater beneficiaries of the ‘network’ effect (eg, Facebook), certain fast-growing technology sub-sectors are only accessible via smaller companies. Security is one example. This hitherto underinvested sector addresses a huge and growing problem for consumers and corporations alike, and consequently offers strong growth to the right companies.
Meanwhile, the sector should benefit from US tax reform encouraging companies to repatriate cash balances held outside the country at lower rates of tax. Not only could this reward shareholders generally through cash returns, but it could encourage M&A activity, which would particularly benefit the sector’s myriad smaller companies. Speaking of which, as Katie Potts has emphasised, the UK economy is considered to be one of the most entrepreneurial and conducive for TMT companies to establish and grow – note the extent of investment in the UK in recent years by the US tech giants.
As for comparisons with the last technology bubble, we should remember there were then no earnings – a variety of esoteric valuation metrics unjustifiably inflated multiples, until reality dawned. This time, valuations are supported by strong earnings growth – averaging 35-40 per cent within the Allianz Technology Trust portfolio. Such growth is rightly prized in a low (and perhaps slowing) growth environment – particularly when captured via companies on around 25-30 times earnings.
Given the characteristics of the sector, there will be periods of volatility that will test investors’ nerves – but the long-term story should be kept in view. Such is our conviction, the eight real portfolios run on our website www.johnbaronportfolios.co.uk, including the two covered in this column, will continue to embrace volatility in order to increase exposure where and when appropriate. Meanwhile, some value can still be found despite the sector’s strong run.
Portfolio changes
During May, the Income portfolio sold its holding in F&C UK Real Estate Investment (FCRE) and introduced Herald (HRI). The Growth portfolio also added to its existing holding in HRI.
FCRE has performed well since its inclusion in the Income portfolio in providing a balanced exposure to the sector. However, looking forward, commercial property in the regions should do particularly well as local economies and certain sub-sectors, such as ‘industrial’, disproportionately benefit from the economic recovery. Hence the retention of the portfolio’s two remaining property holdings, which also ensure the portfolio remains overweight the sector relative to its benchmark.
HRI seeks to achieve capital growth through long-term investment in TMT ‘micro-caps’, mostly in the UK. The company has an enviable track record, producing an annualised growth rate of 11.9 per cent to the end of 2017 since the company was founded in 1994. HRI has usually stood on a wide discount to net asset value, in part because of its unusual remit, but this will change over time as the merits of its sector, together with its investment approach and record, become more widely appreciated.
