Editor’s Note: Our technology sector outlook is part of a regular series sharing our views on various sectors. It’s part of our efforts to increase communication with investors at a time of economic and market uncertainty. While the sector outlooks provide a short overview of our thinking, we invite you to contact us if you are interested in a deeper discussion.
For much of 2020, gains in broad indices were largely concentrated, as a few mega-cap tech companies dominated performance. The FAANG stocks, or as they are grouped more recently, FAANMG (Facebook, Amazon, Apple, Netflix, Microsoft and Google) enjoyed heady returns while most other stocks trailed significantly.
True, some of these stocks fall in the consumer discretionary sector, but for all intents and purposes, they share a common thread: dominant technology platforms that individuals have relied upon heavily during the pandemic.
In 2021, opportunities in the technology sector could widen. This blog looks at a few of the additional bright spots, a few potential headwinds for pockets of the tech sector, and how we are navigating the current environment.
First, the positives:
Several trends should underpin strong semiconductor demand. Most semiconductor demand is cyclical, so a rebound in the economy as we recover from the pandemic would bode well for the industry. But several secular trends could also drive growth. 5G adoption is in the early innings and the number of 5G smartphones could double this year. Both the devices and the wireless infrastructure to support 5G networks will require more semiconductors.
Demand for graphics processing units (GPUs), which facilitate artificial intelligence applications like search recommendations and real-time conversations (e.g. “Siri”), is another tailwind for semiconductor companies. Also, as automobiles become “smarter,” connected and electric, they increasingly rely on microchips. Recent demand for automotive semiconductors has exceeded supply, leading some manufacturers to temporarily pause production.
Digital banking and electronic payments increasingly proliferate. It didn’t receive as much attention, but another trend that pushed forward during the pandemic was the significant growth of digital payments. The “at home” environment and government stimulus were boons for e-commerce and peer-to-peer transfers. Services like Venmo, PayPal, Apple Pay, Google Pay and Square’s Cash App have become ubiquitous, even among middle-aged consumers.
These apps expanded banking and investment services through 2020. Such services include debit cards, rewards and loyalty programs, direct deposit capabilities, small business lending and stock and cryptocurrency trading. Expect this list of services to grow in the coming years.
Consumers and businesses are both paying close attention to cybersecurity. Distributed workforces in a work-from-home environment have put greater impetus on securing computers and networks. The months-long “SUNBURST” attack of large corporations and government agencies has further thrust cybersecurity into the spotlight. A number of smaller, lesser-known technology companies provide securities and benefit from an increased focus on keeping personal and business data safe.
Potential Technology Sector Headwinds
Big tech companies could be due for more regulatory scrutiny. Big tech companies find themselves in the regulatory crosshairs on several fronts. After the events at the Capitol on Jan. 6, there will be growing concern about how information is spread on social networks. Censorship will also be an issue with some politicians. And at a larger level, many regulators are concerned about the power big technology companies have amassed, and whether they are operating in industry structures that are too monopolistic in nature. Should the combination of speech and antitrust concerns garner bipartisan support, it won’t go away quickly.
High valuations for software companies are a concern. Many software companies trade at excessive valuations and are coming off a year in which revenue growth was extraordinary, particularly those exposed to e-commerce or “at home” trends. If these companies can’t follow that revenue growth in 2021, it would not be surprising to see the market penalize them. This is especially true as a wider group of reasonably valued tech companies face improved growth prospects, which could entice some investors to rotate into them.
Telecommunications companies could find themselves in a tough spot. Both wireless providers and cable providers face tough obstacles in the days ahead. Wireless providers are on the cusp of a massive CAPEX cycle to build out 5G networks, and many companies are already saddled with high debt levels. As wireless companies embark on this spending spree and compete to win customers, the return on that investment could be lower than many expect.
Cable operators also face headwinds. Broadband has been a good business for these operators, but it’s not high growth. And there isn’t much growth they can generate from their video business, especially as they compete with subscription services such as Netflix or Disney+. Companies such as SpaceX and Amazon are longer-term threats, as each is planning to launch low orbit satellites to offer broadband quality internet service. Simply put, cable is a tough industry to compete in.
How are we navigating the sector?
We have taken a balanced approach to the technology sector within our portfolios. We still hold some of the mega-cap tech companies, whose platforms should continue to drive growth in the coming years. However, given regulatory headwinds we are managing position sizes carefully.
We have exposure to many of the emerging technology trends that we believe could lead to a broader set of market leaders within the sector. For example, we have exposure to 5G growth through a leading wireless semiconductor company. For cyclical exposure, we own two global diversified analog semiconductor companies. We also own semiconductor equipment makers.
Within the payments space, a couple of the marquee names have lagged the broader market because profitable cross-border payments have been muted while travel decreased during the pandemic. Cross-border payments could be poised for a substantial rebound as consumers gain immunity to the coronavirus.
We’ve approached cybersecurity opportunities carefully. There are dozens of companies tied to the theme, but many are highly valued. This is particularly true in the large cap space. Notwithstanding, we have found a number of attractive opportunities among small cap companies.
Finally, we are especially wary of highly valued companies facing difficult year-over-year comparisons. 2021 should refocus many investors on normalized growth trajectories and this could depress valuation multiples. We also maintain discipline around those companies encountering disruptive competition.
As 2021 moves forward, we look forward to seeing how some of the changing dynamics within the technology sector play out.
