The technology sector has been one of the strongest performers this year, growing 4.3% compared to the S&P 500’s 1.7%.
Moreover, the biggest names in technology are the ones contributing most of the growth, leading to apprehensions that there might be a correction in the not-too-distant future. Never mind that it hasn’t happened thus far despite fears of a trade war with China. So Amazon (AMZN - Free Report) shares are up 39.3% YTD, Microsoft (MSFT - Free Report) is up 15.5%, Apple (AAPL - Free Report) up 10.4%, Facebook (FB - Free Report) 8.7% and Alphabet (GOOGL - Free Report) up 4.4%.
Investor Concerns Aren’t Unfounded
First, because some technology stocks appear to have lofty valuations compared to the rest of the market.
Second, because it’s natural to assume that growth can’t continue forever.
Third, there must be a limit to innovation, somewhere.
Fourth, because many segments within technology have been cyclical, cyclicality may hit at any point, limiting growth prospects.
Fifth, technology companies continue to invest heavily, so when growth rates drop off, we might see the dotcom bubble all over again.
Sixth, the government’s policy decisions have increased uncertainties about environmental issues, labor sourcing and relations with China, all of which impact tech companies.
Seventh, regulatory risk from privacy, security and anticompetitive behavior will take its toll on the sector, and especially, the big players.
But What Makes Me Optimistic
Given the strong run in tech stocks, the S&P 500, which is based on the market capitalizations of 500 large companies listed on the NYSE or NASDAQ, has become decidedly tech heavy. According to FactSet and Fidelity Investments, the sector makes up 25% of the S&P 500 as of March 31, 2018.
And despite the price appreciation, 20% of Zacks Rank #1 stocks are in the tech sector. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
So there are some solid reasons for this-
Application Across Sectors: One of the most important aspects of technology is its ability to improve efficiencies, output and experience across other sectors. That’s why, technology has been adopted in every sphere of our lives whether we know it or not, and this application will only increase in the future.
Emergence of Platforms: All of the big technology players are platform providers such that they can’t be dispensed with or ignored. In fact, the need to adopt technology to drive efficiencies, experiences, or simply to market to a wider audience, drive companies to platforms that can maximize their return on investment. In this process, the platform providers just can’t lose out.
What’s more, in areas like cloud computing for instance, we don’t need to pick a favorite between Amazon, Microsoft, Google and others because there’s room for many players and it doesn’t need to be a winner take all kind of thing.
In social networking, while theoretically, there’s no bar on other companies entering the space, momentum and scale are big factors. So we’ve seen countless reports of how teens are ditching Facebook and how the Facebook fever is running down, but the social network seems to be doing just fine. Even after the recent data scandal, surveys showed that not a large percentage of people want a pay service. The thing that makes them stick is the platform, where you know what it offers and you simply can’t get that scale anywhere, any time soon.
Amazon’s ecommerce platform utterly dominates the online retail space and the company continues to offer a seemingly unending supply of items. Amazon’s platform is compelling and while most traditional retailers also have some online retail presence these days because of its obvious advantages, the ones that build a strong platform will the ones that survive. This of course also means the adoption of boatloads of technology.
Even a much smaller company like Netflix (NFLX - Free Report) could make headway because of the platform it offers and its first mover advantage.
Proliferation of the Internet: Internet penetration has been increasing across the world and believe it or not, there’s scope for it to increase much further. So there have been conversations about market saturation and how that could limit the scope of Internet focused companies. But that perception is changing gradually because of the advent of the Internet of Things (IoT), where the Internet that earlier lived only on computers and later, also on mobile devices, is now spreading to every single thing that we use.
Data Science: Data science stems from the belief in the basic interconnectedness of all things, both human and otherwise. So by repeatedly studying behavior under certain circumstances, machines can predict with reasonable accuracy the likely future behavior on the recurrence of the same circumstance (machine learning). But to arrive at these results requires millions of calculations in near real time, to study real world phenomena, compare with past known results and come to a conclusion/decision, then called artificial intelligence.
Data is the key word here, so the entities with the most data are the strongest positioned, along with the ones providing the technology like Intel (INTC - Free Report) , NVIDIA (NVDA - Free Report) , Micron (MU - Free Report) and others. This market didn’t even exist a few years ago and we haven’t even scratched the surface yet.
Financial Discipline: While technology companies have been investing heavily in new opportunities, there has been a kind of thrift built into them since the dotcom era. They have been curtailing production when required and taking temporary losses rather than building inventories. Even a company like Alphabet changed its CFO to bring financial discipline. When Amazon was more of a retail company, its infrastructure buildouts had a significant impact on its earnings. Now that it has started taking in more tech-style profits, infrastructure costs are far easier to handle.
High Profit Margins, High Cash Balance: Since technology helps us do everything more efficiently, the biggest use case for tech is its ability to drive value, which is why the sector commands higher margins and stronger cash flows than most others, making it attractive for investors.
It’s great that technology now makes a big portion of the S&P because the sector has legs. Despite all the recent growth, there is plenty of scope for more. Valuations aren’t that high yet for most companies because the scope of growth isn’t properly understood. But this is one sector with multiple growth drivers, for many years to come.
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