While many businesses struggle to survive under the global lockdown, despite reaching historically high valuations in February, tech stocks have emerged relatively unscathed. In some cases, they are even thriving, benefiting from secular trends toward remote working, digitalisation and cloud computing as well as more robust telecommunications infrastructure, which have only been accelerated by the response to Covid-19.
“With close to half of the world’s population in containment, the need to maintain a ‘normal’ life has caused an acceleration of several long-term trends,” says Julien Lafargue, head of equity strategy at Barclays Private Bank. “People have been forced to shop online, work remotely and entertain themselves while being stuck at home. This has boosted adoption for online retail, cloud computing and streaming.”
Moreover, many emergency behavioural shifts observed today will likely become permanent, adding to tech firms’ business case.
Driving the market
Tech stocks have significantly outperformed the broader market, both over the past few years and year-to-date, so that the top five companies in the S&P500 are all technology companies, namely Facebook, Amazon, Microsoft, Apple and Google.
These tech giants are increasingly driving US equity returns. Between 2015 and 2019, the ‘Famag’ stocks contributed around a third of the total 74 per cent return delivered by the S&P 500 index. Since the outbreak of the crisis, their outperformance has further boosted their combined market-cap weight to reach nearly 20 per cent of the S&P 500 index today, from roughly 8 per cent in 2015. These five stocks now account for a larger slice of the US index than at the peak of the dotcom bubble in 1999.
“As smaller businesses and start-ups flounder, this pandemic will likely make the largest tech firms even more powerful than before,” states Sean Markowicz, strategist, research and analytics at Schroders.
Microsoft has reported a surge in usage of its cloud computing service Azure, as millions of people work from home. Amazon is hiring an additional 75,000 workers, on top of the 100,000 it hired in March, to cope with increased demand for its online delivery service.
The number of video calls and messaging on Facebook has exploded, while a record number of gaming apps were downloaded in China from Apple’s app store. YouTube Kids, owned by Google, was the most streamed app in the first quarter of 2020 according to a report by Apptopia and Braze, following the closure of most nurseries and schools.
“Travel restrictions and social distancing rules imposed as a result of the coronavirus have dramatically increased our reliance on these digital platforms to service our basic needs, entertain ourselves and stay connected with friends and colleagues,” says Mr Markowicz.
But is their performance sustainable?
The Famag stocks tend to have above-average cash buffers, relatively few short-term liabilities and strong cash generation capabilities, while the balance sheets of other tech firms are not in such resilient shape, leaving them vulnerable to acquisitions. The UK competition watchdog’s approval of Amazon’s investment in food delivery company Deliveroo confirms the trend.
Yet, these market leaders are not completely shielded from the economic effects of the global lockdown. Despite traffic going up on social media platforms, many advertisers have cut spending, affecting online advertising. Moreover, although the regulatory pressure has eased in the short term, considering the public role these firms are playing in the crisis, “more regulatory scrutiny could slow down future M&A expansion, which has an important ingredient of their success,” predicts Mr Markowicz.
Also, increasing market concentration should be ringing alarm bells, as there is poor track record of dominant firms maintaining their dominance over time. According to the McKinsey Global Institute, nearly 50 per cent of all market leaders fall out of the top 10 per cent during the business cycle. Today’s dominant firms could be tomorrow’s Nokia or Blackberry.
In general, however, strong growth and, in some cases, a relatively higher degree of visibility over earnings given a recurring, service-based business model, make tech stocks particularly sought after in an environment like today’s, where economic growth is subdued and uncertainty is elevated, says Barclays’s Mr Lafargue. This explains why most of them, especially those experiencing a high degree of growth, have exhibited a noticeable valuation premium.
This is probably the most supportive backdrop in which it makes sense to own tech stocks, he adds. If economic growth picks up, investors may be reluctant to pay a premium for the growth and visibility that the technology sector offers, and tech stocks may lag. But this could represent a buying opportunity. As long as companies can grow revenues and profits, their stocks should appreciate over time.
Valuations of tech stocks have improved from where the market peaked in mid-February. On a price to forward earnings basis, the sector now trades at around 6 per cent premium to the S&P500, which is down from a 23 per cent premium in mid-February.
Their strong cash flow generation and their ability to capitalise on the trend towards digitalisation make tech stocks attractive, given the environment of subdued demand, says Frédérique Carrier, head of investment strategy at RBC Wealth Management.
However, despite secular growth opportunities, stretched valuations relative to their historical values drive the bank to have a neutral allocation to tech stocks.
Tech stocks may be vulnerable to future bouts of volatility, which may offer better entry points to build positions in this space. “When stocks become over-owned, and overly popular, this is where people decide to take profits when they want to come out of the market. That would be one of the challenges,” warns Ms Carrier. Also, the trend towards digitalisation can be played through other types of equities, potentially less expensive, such as consumer discretionary or industrial stocks, she adds.
Shift in consumer habits
The enormous dispersion behind the recent market meltdown is a source of investment opportunities, especially in secular growth areas which have outperformed year-to-date, says David Older, head of equities and fund manager at Carmignac.
Within them, opportunistic winners include grocery, video games and fintech companies that allow digital payment, all benefiting from a big surge of ecommerce. Companies in the telehealth space are also booming. Ping An Good Doctors in China, enabling patients video access to a network of 9000 doctors, has surged 45 per cent since the outbreak this year.
Despite the US economy slowing 4.8 per cent in the first quarter, Facebook and Google experienced digital ad growth in the US of 19 and 15 per cent respectively, which shows the strength of their business model, based on their ability to capture customers’ data, understand their preferences and offer targeted advertising and higher returns to advertisers. The halt in TV production and sports programmes caused by the virus is further accelerating the trend towards digital advertising.
“There will be more and more restrictions on data usage and collection, and limited growth of companies utilising data, but their business model is so powerful versus other tech advertising business models, such as TV where nobody knows who is watching what, that the momentum continues,” adds Mr Older.
Demand for cloud infrastructure is also growing exponentially, with Microsoft Azure and Amazon Web Services clear beneficiaries. As people are staying at home and interacting digitally, they use streaming technologies, such as Microsoft Teams, Netflix or Zoom, which use cloud infrastructure.
An important metric to assess consumer-driven internet companies is their customer acquisition cost (Cac). Video communication firm Zoom has seen a massive adoption curve since the coronavirus outbreak, with daily users of its platform rising from 20 million in February to 300 million today, many of which were acquired inexpensively.
HelloFresh, the online German meal kit delivery company, historically took eight months to break even on newly acquired customers, but the coronavirus has led to a surge of new customers at zero cost, accelerating the development of their business case.
But as lockdown policies ease, and economies reopen, is there the risk that these trends reverse themselves?
If companies like Zoom can retain 20 per cent of their newly acquired customers and turn them into paying customers, and similarly HelloFresh, or Amazon, can retain a proportion of their inexpensively acquired customers, that would be “very positive” for their business, states Mr Holder.
Changes in digital consumption trends forged during the crisis could result in long-lasting shifts in consumer habits, which could benefit tech stocks.
“One clear trend is that people will want to work from home more often and businesses are fine with that, because they have seen great productivity from workers,” says Mr Older.
Companies, on their side, want to safeguard against future shutdowns and cut costs and are looking to shift their computing workloads online so that employees can access their data from home. This would be a boon for major cloud server providers.
The smooth transition to a work-from-home model globally has been made possible by the availability of cloud IT infrastructure and its services, which would have been unconceivable 10 or 20 years ago, says Stéphane Monier, CIO at Lombard Odier
“The secular trend towards a gradual adoption of the cloud infrastructure has matured and expanded tremendously, and even though lower costs and security concerns dominated early discussions, the pandemic provided the ultimate argument to help overcome any hesitancy,” he adds.
Flexible IT platforms are essential to swiftly shift a large portion of employees to a work-from-home professional environment. Deploying additional servers and software in a cloud datacentre is much easier than on site. Cloud removes the rigidity of on-premise IT equipment requirements and allows for scaling of resources in a remote and fully controlled way, making redundant equipment for contingency requirements, security experts and tools.
“Today, the cloud competitive landscape is polarised. On the infrastructure and platform side, only a handful of companies have the required resources to continually invest and harvest economies of scale,” says Mr Monier.
Amazon AWS, Microsoft Azure, Alphabet Google Cloud and Alibaba AliCloud are industry leaders. By contrast, the cloud software space is much more competitive and the barriers to entry lower, as new start-ups leverage the cloud infrastructure. A few large incumbents, such as Salesforce, SAP, Workday, Microsoft, and Oracle, compete with long list of thriving, highly specialised software companies.
This is way many technology companies keep large cash reserves, to speed up their time to market by acquiring the most promising start-ups. “We could potentially see a rise in M&A activity in the coming months, regulators permitting, as the bid and ask spread between acquirers and potential sellers narrows due the softening economy.”
Digital transformation
Despite near-term demand conditions becoming highly uncertain for all sectors, including technology, companies ahead on the digital transformation trend will lead during and after the crisis, predicts Jonathan Curtis, research analyst and portfolio manager, Franklin Equity Group. “Many of the behavioural shifts that we are observing across shopping, entertainment, healthcare and work are likely to accelerate the trend of digital transformation. This is one reason the technology sector has held up well during the crisis.” Technology has proved to be “the antidote” to many of the challenges that the pandemic has created, and underlying all digital experiences has been the robust and pervasive cloud computing platforms, which help technology companies scale their solutions quickly across the globe.
As the crisis ebbs, there will be a shift back towards more normalised behaviour, but people and businesses will have learned new skills and found that many of the digital experiences they are having today to be just as good as, or in some cases better than, the status quo, he says.
Vendors of technology that enable these new experiences, and the companies that successfully leverage them are likely to experience long lasting productivity improvements. Conversely, the digital transformation laggards will face tough questions on why they lagged their peers during these difficult times and be forced to start their own digital transformations.
“All businesses will need to invest more in digital technology to better understand and service their customers and partners at a competitive cost. Those businesses that do not make these investments, risk being disrupted by nimbler digital natives,” adds Mr Curtis.
Tech themes
Long-term investment themes around technology and digitalisation, which strongly resonate with private clients across geographies, have been strengthened by the healthcare crisis.
The investment theme “technology at the service of humans”, launched by Credit Suisse in 2017 under the bank’s supertrends framework, continues to be relevant today, and is likely to get a boost from the pandemic, says Daniel Rupli, head of single security research, equity and credit at Credit Suisse. The theme focuses on digitalisation, virtual and augmented reality, industry 4.0, artificial intelligence and healthtech.
As companies understand the need to scale up remote work capabilities, public cloud adoption will become faster post-Covid-19. Video collaboration tools, live streaming of events or exhibitions in virtual reality could become a new normal and might see a strong breakthrough. Online doctor visits which until recently had received push-backs from regulators might also become the norm. As a result, data traffic will grow exponentially, driving up datacenter demand, benefiting companies able to monetise data, adds Mr Rupli.
With ever-increasing data usage, digitalisation and automation, cyber security remains a key risk, with phishing attacks and increased cyber crimes during the past few weeks making this theme even more relevant.
Another supertrend, ‘millennials’ values’, is also linked to technology. These digital natives, which represent 50 per cent of the world’s population, are driving the long-term shift in consumer behaviour towards subscription-based content, products and services. Digital content consumption is at the forefront of this move, with the success of music and video streaming industries, while eSports, often taking the form of organised, multiplayer video game competitions, are becoming ever more popular.
The convergence between old and new economy sectors is a multi-year theme Standard Chartered has focused on, and which the pandemic has accelerated. This includes autos and sensors, manufacturing and robots as well as big data and logistics.
The convergence of big data and logistics is improving efficiency in areas including the pricing of food delivery services, matching surplus capacity - such as taxi and on-demand drivers - with excess demand, for example goods delivery, explains Steve Brice, chief investment strategist, Standard Chartered Private Bank. It also enables spotting spikes in Covid-19 infection using mapping software and diverting medical supplies to these areas in anticipation of a spike in demand.
“Streaming, cloud computing services and the convergence between old and new economy sectors, specifically logistics, will be big winners from Covid-19,” he concludes.
