Within the global economy, COVID-19 has acted as a formidable accelerator of trends driving disruptive technology. Valuations of information technology stocks have soared, raising questions about the extent of the rally. Guy Davies, chief investment officer for fundamental active equities, explains why this time may be different.
COVID-19 has undeniably led to an acceleration in select secular growth themes and, currently, there’s no sign of that letting up. For instance,
- Cloud computing
- Agile working – the ability to access, process and be productive almost anywhere
- Entertainment on demand – we can travel with our entire collection of movies, music, books, photographs and so on
- Remote care and support – accessing healthcare systems or online medical consultations.
- E-commerce and digital payments, reflecting people’s preference to shop from home and avoid using cash
- Automation, both via software and physical robots, which enables more localised manufacturing in response to more strained global supply chains.
Hence, while there are valid reasons for believing that there may be respite in the rally of those stocks that have obviously been propelled by COVID-19 related factors, the secular change associated with the cloud, AI and automation has much further to run.
The fundamental drivers of disruptive technology
Among the key factors driving disruptive technology are innovation and motivation, but the fundamental driver in our view is digital transformation. This makes existing processes more efficient and enables new products and services, all of which are central in tackling some of today’s most pressing challenges.
Some areas in which digitalisation can help include:
- Inequality – access to broadband can enable the provision of remote healthcare and improve financial wellbeing through online banking
- Climate change – the datacentres that power the cloud require significant amounts of energy; solar and wind energy, which rely heavily on digital processes, could represent more sustainable long-term solutions
- Healthcare – remote healthcare and telemedicine could help to increase the capacity of our healthcare systems. Similarly, artificial intelligence and data analysis can be used to predict and manage the spread of infectious diseases.
Valuations of tech stocks
On a historical basis, tech valuations are high compared to the last 10 years, but in my opinion, these stocks do not look excessively expensive when you look back 20-25 years. That is to say, valuations are not beyond the sort of levels we saw back in 2000 during the tech bubble.
Within the tech sector, valuations for software stocks do look extended, but there’s also a lot of dispersion between companies. Indeed, this is not a rising tide that has lifted all boats, there are discrepancies and fragmentation in pricing between and within tech sectors, which creates opportunities. I can point to certain stocks that look cheap – based on growth in margins, market share and the net addressable market. Others appear expensive – companies that are yet to make a profit or generate free cash flow, but that are already trading on lofty valuations.
Hence, I think you need be company-specific and examine a range of valuation metrics (DCFs, PE, P/CF, growth rates and ROIC/CFROI) for all companies – and most importantly the moats and sustainability of these growth rates and returns on capital. The leaders in each sector tend to have the best technology, but also reinvest the most for future growth. And this in and of itself becomes a virtuous circle.
A very particular context
Finally, it’s also important to consider the context; in a low growth, low rates, low inflation world, how should we value these global leaders?
It is already apparent that the COVID-19 crisis has launched a new cycle of low growth coupled with high debt burdens – governments and central banks in developed countries have little choice but to prop up the real economy by ensuring businesses have the funding they need.
As a result, some of these companies’ future profits will have to be set aside to repay debt. A low interest rate world could arguably allow valuation multiples to remain high, even during a cycle trough.
In this environment, only the best companies, positioned in the few high-growth segments, and running their business with sound capital allocation and without financial engineering tricks to inflate earnings will be able to match these expensive valuation multiples with earnings growth. In a world of predominantly low growth, this type of growth will be the kind that lasts.
Financial value is therefore less likely to be generated through asset allocation as it has in the last 30 years of continuously declining interest rates. Instead, I believe stock picking will come to the fore as the cycle of ever-lower interest rates ends and the gap in performance between the leading companies and the rest of the pack widens.
 There are various methods of valuing stocks. Read more at https://www.investopedia.com/articles/fundamental-analysis/11/choosing-valuation-methods.asp