Equity Insights offers research and perspectives from Putnam’s equity team on market trends and opportunities.
This month’s authors: Neil Desai and Di Yao, Portfolio Managers
The first half of 2022 was anything but pleasant for investors, especially those with exposure to the technology sector. Tech stocks across global markets experienced violent sell-offs, and tech indexes are now firmly in bear market territory. This comes with the added challenges of inflation at 40-year highs, an increasingly aggressive Federal Reserve tightening stance, and mounting worries about a potential recession. In managing our tech portfolios, we are presented with a classic but not unfamiliar challenge: looking beyond the extreme volatility to find attractive long-term investments.
Valuations were simply not sustainable
There is no shortage of macroeconomic pressures and geopolitical risks to blame for the carnage in technology stocks. However, we believe it is largely a belated correction after abnormally stretched valuations and significant outperformance for the sector over the past decade. The MSCI World Information Technology Index reached a valuation peak on January 21, 2021, with a price-to-earnings multiple of 30.6x (and higher for some pockets of unprofitable tech). It was the sector’s highest valuation level since the dot-com bubble burst 20 years earlier, and it was considerably higher than the long-term average. These excessive valuation levels persisted for much of last year before starting to show signs of cracking last November. At the close of 2021, the index delivered a 30% annual return and an annualized 3-year return of 40%.
At today’s level, technology valuations are close to their long-term average, but in our view, they are not screamingly cheap yet. As of June 23, the MSCI World Information Technology Index traded at 19.6x, compared to a 10-year average of 19x and a 5-year average of 22.5x. Notably, though, earnings estimates for the most part have not been adjusted to reflect an economic slowdown, shallow or deep. While early, we are just now beginning to see some tech bellwethers incorporate some caution in their outlooks. However, many are still blaming their downgrades on transitory issues, such as foreign exchange and supply shortages, rather than broad-based demand weakness. We believe that will be the next leg as we readjust, and heightened volatility could continue for the next several months.
Is there any good news?
Where does this leave us? The good news is we do not have to blindly own the entire sector. We actively manage portfolios with the flexibility to focus on bottom-up, fundamental analysis and identify attractive risk/reward profiles. Even in tough markets — often especially in tough markets — our deep research and experience from past cycles can help identify compelling opportunities for our portfolios. Of course, as part of our process we strive to remain intellectually honest and adjust accordingly based on new or changing data or circumstances.
Industry to watch: Chinese internet
Many investors chose to step away from China’s tech stocks in the past two years, describing them as “uninvestable.” This was based on deep, swift, and never-before-seen regulatory actions in China, beginning in late 2020. Some of China’s largest technology companies experienced unprecedented intervention from the Chinese government, which led to a sharp, indiscriminate sell-off across the entire Chinese tech stock landscape.
Recently, however, we have started to see some policy easing from the Chinese government in a bid to help offset economic headwinds. This, in our view, also reinforces the government’s long-term support for technology companies. Growth is a vital component of its “common prosperity” goal, and the digital economy is only becoming more important to China’s growth formula. China’s internet companies will likely continue to be major contributors to — and potential beneficiaries of — these shifts, in our view. Broadly speaking, we believe some of these Chinese internet companies offer attractive secular growth potential at value prices. As such, they warrant our time and consideration for a portion of our investment allocations.
It is true that many high-quality, large-cap internet platform companies have seen their market valuations halved and are also arguably trading in value territory. That said, China is loosening monetary policy, contrary to most other global markets, and could potentially enter an economic expansion cycle in the second half of 2022. Trough valuations combined with positive earnings upgrades could pave the way for potential outperformance in an area of tech that many investors have exited completely. We see opportunity in Chinese e-commerce platforms Alibaba and JD.com, along with local services player Meituan.
Even in tough markets — often especially in tough markets — our deep research can help identify compelling opportunities.
Industry to watch: Semiconductors
While we were largely bullish on semiconductors for the better part of the past two years, we now have a more cautious approach to the subsector, as companies may be shipping more chips into end markets than can be justified by demand. We believe many chip companies are likely to see large earnings downgrades later this year and in 2023 as demand falls in certain end markets. However, in our view, some companies will continue to be buoyed by strong long-term semiconductor trends such as the accelerating adoption of electric vehicles. Also, we expect semiconductor equipment stocks, which serve as “picks and shovels” for the industry, will be less impacted as global supply chains are reshuffled and expanded.
One example is Dutch lithography machine maker ASML Holding. ASML manufactures some of the world’s most advanced lithography tools using extreme ultraviolet light. Regardless of a near-term slowdown in demand, we believe ASML may benefit as businesses continue to expand manufacturing capacities as part of their strategic, long-term capital expenditure plans.
An entirely new set of technology trends
We expected 2022 to be a year of normalization. And so far, that has been the case in areas such as supply chains, public health, consumer behavior, and interest rates. The past few years and the Covid-19 pandemic have fundamentally changed the landscape in ways that will largely shape the next decade of technology trends.
As almost every life experience becomes more digitally connected, we see businesses ranging from internet giants to vertical software vendors becoming more critical to enabling this transition. Regardless of current challenges, long-term tailwinds include demand from businesses for cloud computing, software as a service, and the digitization of their enterprises. We believe there remains a long runway for growth as tech companies penetrate these massive addressable markets.
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