There are two competing macro forces acting on the technology sector: rising interest rates and inflation. The two are linked but they have opposite effects on the market capitalisation of the sector. Rising interest rates squeeze valuations. However, what is less well understood is that inflation is good for the long-term earnings of the companies of the future. The first part of this argument is clear. The second part of it we will come to a bit later.
We all know that rising rates mean bigger discounts being applied to future cash flows. Since the beginning of the year, the price to earnings ratio of the tech-heavy Nasdaq has fallen from 27 to 19 times. Ark Innovation ETF (US:ARKK), which owns some of the most speculative companies in the world, has seen its valuation drop 58 per cent this year and Baillie Gifford’s Scottish Mortgage Investment Trust (SMT) has dropped 40 per cent.
For institutional investors, this is just simple maths. When rates rise they change their discount cash flow models and valuations fall. For retail investors, their decision-making process might be different. The rising cost of living will be encouraging them to sell shares to pay for bills. There is also the power of narrative – to which institutional investors are also vulnerable. When prices are falling, less patient investors get spooked and exit their positions.
However, if you are serious about investing in growth stocks then your horizon should be a lot longer than a couple of months or even a couple of years. The companies that technology funds such as Scottish Mortgage Trust (SMT), Polar Capital’s Global Technology Fund (PCT) and Cathie Wood’s Ark ETF are invested in are likely to be essential to our future, not in two years’ time, but in 10 or 20 years.
Digitisation is dematerialising the world
Now what exactly does this future look like? Well, this future is sustainable, which means using less hydrocarbons and less resources while still increasing our well-being. To achieve this, digitisation will be an essential component. Andrew McAfee’s counter intuitive book More from Less showed how America has been able to decouple GDP growth from resource consumption since the turn of the century.
US consumption of metals, fertiliser, concrete, timber and energy have all peaked in absolute terms. Between 2000 and 2015, consumption of steel fell 15 per cent, aluminium 32 per cent and copper 40 per cent. Energy consumption, which has always been directly correlated with GDP, fell 2 per cent between 2008 and 2017 while GDP expanded by 15 per cent.
How has this happened? Capitalism, the profit function and innovation. “Essentially, we invented the computer, the network, and a host of other digital tools that let us swap atoms for bits [think, for example, of how many different devices and media have vanished into the smartphone],” explains McAfee.
The reason why companies are encouraged to reduce the amount of resources they use is because it is cheaper. Lower costs mean more profit and more cash. The creation of the iPhone removed the need to have a separate camera, music player and phone. This allowed Apple (US:AAPL) to consistently generate returns on equity of over 30 per cent and become the most valuable company in the world.
CEO of Microsoft (US:MSFT) Satya Nadella, says the digital economy will be a powerful deflationary force and expects more digitisation in the next 10 years than we have seen in the last 40. Polar Capital fund manager Alastair Unwin agrees with this hypothesis, "inflation can drive faster adoption of technology as companies look for ways to take people and materials out of the production process, AI is going to be enormous here for material sciences."
The incentive to dematerialise is about to get a lot stronger. The war in Ukraine has pushed up the price of Brent crude oil by 30 per cent to over $100 a barrel this year, fertiliser prices have almost doubled and unionised workers are pushing for pay increases. At the same time, national security issues are driving a deglobalisation which will give companies less access to cheap foreign labour.
Tech companies are benefiting
To respond to these inflationary forces and maintain healthy profit margins, companies will be forced to digitise faster. Microsoft has been struggling to get its hands on the Nvidia RTX graphics cards for its new Xbox console so have just launched an Xbox TV app that will allow Xbox Game Pass Subscribers to play more than 100 games over the cloud. BT, which is about to face a strike, has already been investing in AI chatbots to reduce the number customer service employees needed.
Every time a company switches a “thing”, such as a console or an employee, for a digital service, it creates data that needs to be stored on the cloud. Revenue growth for Microsoft Azure accelerated 300 basis points last quarter to 49 per cent year on year. For Amazon (US:AMZN) Web Services, the pace of growth slowed slightly, but was still a very healthy 37 per cent year on year. At Alphabet (US:GOOGL), the cloud business saw sales rise 44 per cent.
In manufacturing, digitisation comes in form of 3D printing and robotics. 3D printing, also known as additive manufacturing, was much touted in 2010 but has yet to fully take off because the unit economics were still not profitable. However, the technology has been improving and the fact that it is much more energy efficient than injection moulding means rising energy costs will drive further adoption.
In May, president Biden met with five leading US manufacturers to launch the “AM Forward” initiative. The objective is to help smaller US -based suppliers increase their use of 3D printing to create a more robust domestic supply chain.
Materialise (US:MTLS), a company in the Ark Innovation ETF, creates the software that enables 3D printing machines and has forecast 2024 EPS of 35¢, 84 per cent higher than last year's figure. This earnings forecast has been steadily rising since March. However, in that same period its share price has fallen 30 per cent. The valuation may have compressed but the medium-term earnings outlook has been steadily improving. As the chart shows, it is a similar story at big players like Microsoft.
Copper and oil prices have been falling this month on the back of recession fears. This has caused long-term US Treasury yields to fall as the market expects a short recession to break the back of this inflationary period. It’s no surprise Nasdaq is up almost 5 per cent in the last month given that fears of severe interest rate rises are now abating.
All of this should be trivial for technology investors. Regardless of the short-term macro forecasts the future is one of digitisation and dematerialisation. If the impact of the geopolitical uncertainty is less oil, less trade and more expensive labour then we are only going to arrive there faster. For tech investors, that means long-term future cash flows may soon become medium-term ones.
This doesn't mean all growth companies are guaranteed successful futures. Ark Innovation has big positions in Zoom (US:ZM), Robinhood (US:HOOD) and Coinbase (US:COIN). Yes, video calls and retail investing will be a part of our future but these companies don't have any significant, innovative technology that assures their place in society. That said, automatically dismissing growth companies off the back of interest rate rises would be as foolish as those crypto evangelists who bet their future on Ethereum when the US government started handing out checks to anyone with a registered post code.
