The high-tech sector has seen a dramatic correction and high market volatility in recent months. We believe it is now appropriate to review the outlook for disruptive tech thematic investing. We are confident in the long-term outlook for this secular growth theme as we see many opportunities to invest in companies that are leading – and benefiting from – digital transformation.
Here, we review the risk factors, opportunities and key areas of debate. We also take a closer look at the potential for semiconductors as a vital foundational technology for digital transformation.
Several key risks remain for growth and technology stocks.
We have seen a significant rotation from growth to value stocks, driven in large part by increasing inflation and rising interest rates. This rotation could persist.
Many high-growth companies that invest heavily in products and sales capacity are longer duration assets with a higher portion of their projected cash flow generation further into the future than is the case with more stable growth and value companies. These stocks have recently undergone a significant contraction of their price/earnings multiple.
The risk of recession is increasing as the US Federal Reserve and other central banks tighten financial conditions to combat inflation. Additionally, the Russia/Ukraine conflict and associated sanctions on Russia are creating macroeconomic headwinds. Tariffs, Covid-19 response measures, semiconductor shortages and freight bottlenecks are all fuelling supply chain disruptions.
Finally, in the ‘Big Tech’ sector, there are risks related to antitrust and other forms of regulation.
Despite these risks, we see many reasons for optimism. We are confident in several long-term secular growth themes that are driving the digital transformation of the economy. We believe companies will continue to invest if they see digital transformation as an imperative to remaining competitive.
For example, the adoption of cloud computing continues to accelerate. IT research and consultancy Gartner has raised its projection for 2022 to USD 500 billion, 37% higher than the level predicted in November 2020.
In addition, we see the increasing adoption of artificial intelligence (AI), which is becoming a foundational technology with a proliferation of applications, automation, the Internet of Things (including at-the-edge processing – data processing as close as possible to its source to reduce delays by minimising the communication time between ‘clients’ and servers), and financial technology.
Disruptive technology trends are enabling the creation of new products, services and business models. They are making operations more efficient. In short, they are transforming the way we live and work.
One of the main debates in the sector is the extent to which the increased demand of the first two years of the pandemic is sustainable. For example, e-commerce growth is returning to pre-Covid levels as in-person shopping and experiences recover.
A second major topic is whether valuations have compressed by ‘enough’. We see compelling valuations across the spectrum of companies that we monitor. We believe companies that lead and/or benefit from digital transformation and the related secular growth themes will generate strong revenue, earnings and free cash flow growth over a long investment horizon.
Most of the multiple compression has been from within the higher growth cohort, where multiples are now down by 72% at 10.6x, based on data for companies expected to grow annual revenues by 30% or faster. The slower growth cohort (projected annual sales growth of 15% or less) is now trading at 4.4x, 20% below the trailing 5-year average and in line with the 2014-2018 average.
Out of consensus – semiconductor super cycle
In the semiconductor segment, we strongly believe that the secular growth drivers are so compelling that any inventory correction is likely to be short-lived and unlikely to impact all segments of the industry simultaneously. We are comfortable with our overweight position to maintain our exposure to the positive long-term trends.
Currently, demand for semiconductors far outstrips supply despite evidence of slowing personal computer and smartphone sales. So, the industry may be able to absorb a mild recession without falling into oversupply.
We believe that the primary drivers of increased demand for semiconductors are the secular growth trends underlying digital transformation. Semiconductors are a foundational technology for cloud, AI, automation, and IoT. The industry’s end-markets have broadened from mainframe computers to PCs, to smartphones, and now to diversified industrial, car and high-performance computing applications.
This diversification helps to reduce the industry’s demand volatility as no end-market dominates.
On the supply side, the structure of the semiconductor industry has dramatically improved. The advent and success of the foundry business model has enabled innovation and has concentrated manufacturing among a smaller number of companies.
The supply of memory chips has also consolidated to a handful of manufacturers. This has resulted in more strategic capacity decisions and less risk of structural oversupply. The increasing capital intensity and technology complexity are significant barriers for new entrants.
Looking ahead, we see the potential for continued strong growth for the semiconductor industry, led by automotive and high-performance computing (HPC) applications.
Secular growth and compelling valuations
In recent months, the market environment has been difficult for growth and technology investors due to macroeconomic headwinds.
However, the digital transformation of the economy will continue and we remain constructive on the secular growth drivers underpinning this trend. Valuations appear more compelling in the wake of the recent correction and we are steadfast in our commitment to our investment philosophy.
 Morgan Stanley, Keith Weiss – May 15, 2022 – ‘Valuation Views 5-15-2022: Bouncing Along the Bottom’
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