It is not long since technology stocks were the darlings of the investment world. The biggest companies in the world could be found in this space, growing at breakneck speed and valuations skyrocketed as a result.
Covid-19 only served to increase this trend. Lockdowns meant huge swathes of the population worked from home, carrying out business meetings online, children were schooled virtually and doctors seen digitally. We might not have been able to go to concerts, the cinema or the gym but streaming services boomed, online exercise increased and video gaming reached new highs.
But as economies have gradually opened up, demand for some of these services has been in retreat. Was the digital response to the pandemic a sign of things to come, or will we all return to the way things were before?
Netflix was one of the biggest beneficiaries from the pandemic, says David Older, head of equities at Carmignac, seeing a huge rise in the number of subscribers as we were all stuck at home. The company realised that Covid was giving it a huge boost he says, though assumed it would return to pre-pandemic growth levels once things returned to normal. That has not happened though, with the streaming giant reporting it lost 200,000 subscribers in the first quarter of 2022. Issues such as password sharing between households and the firm pulling out of Russia following the invasion of Ukraine have not helped either.
“So all these things coming together is really adding to the difficulty of forecasting its business,” says Mr Older. “Netflix was a $300bn plus company six to nine months ago, now it is down 70 per cent from that number, so a massive correction in one of the original Faang names.”
It is a similar situation at Paypal he says, which was seeing about 35m new accounts per year pre-Covid, which jumped to 72m in 2020. “The belief was there were lots of potential customers, many of them older people, that all of a sudden needed a digital payment system to access e-commerce, and that these would be permanent accounts.” The company got its projections for new customers “completely wrong”, says Mr Older, and it too has seen valuations drop by 70 per cent.
The damage that has been done to the tech sector over the past six months or so has been “somewhat explainable”, says Jonathan Curtis, portfolio manager of the Franklin Technology Fund, as we are in an era of rising inflation and interest rates and what investors are willing to pay for growth has been falling.
“But there’s also evidence of indiscriminate selling,” he reports. “Some investors, maybe those who visited the tech space over the past two years or so, didn’t really understand what they were buying. And now when they’re selling it, they don’t really know why they’re selling it.”
Yet Mr Curtis believes that well capitalised companies can use this period to consolidate market share and pull away from their competitors.
On the other hand, those smaller companies, who are less well funded and are still figuring out their business models will struggle to get access to capital markets. “I think those companies are the ones where there are real fundamental troubles,” says Mr Curtis.
The Franklin fund has gone from being one of the best performing tech funds in the market to one its more challenged over the past six months. This is due to the fund targeting growth names, which have struggled, and it also has exposure to small and mid cap names.
“I think investors are nervous about the ability of these companies to navigate a recessionary environment,” he explains, though stresses he believes the fundamentals are quite good for his portfolio. Indeed, Mr Curtis has added to names which he already held and which have seen falling valuations.
Solid reasons
The tech and innovation companies did not reach such high valuations without good reason, believes Jon Guinness, portfolio manager at Fidelity International. “For the first time ever, I would argue, we’ve had a number of cycles happening at the same time. The shift to the cloud, the rise of 5G, cryptocurrencies, electric vehicles, augmented and virtual reality and so on, all at a time of incredibly low interest rates.”
Once you added in the pandemic, this sent the already steep valuations even higher and created some “classic frothy behaviour”, he says, and now we are seeing the “puncturing” of that.
People are “really scared”, believes Mr Guinness. Many funds have huge holdings in tech stocks, and some are closing their books or being forced to deleverage.
Yet the fundamental trends which drove the valuations of these stocks still hold true, he argues. “Banks are moving to the cloud, 5G is being rolled out and electric vehicles are here to stay,” he points out. “But at the margins there is froth that needs to come out, companies with insane valuations that need to come down, and it will be painful for people, at least for a while.”
Because valuations in the technology sector have dropped to levels not seen since before the pandemic, they have become more attractive, argues Tony Kim, lead portfolio manager of BlackRock’s BGF Next Generation Technology Fund. “Fundamentals have remained strong in certain sub-sectors – such as software and semiconductors – while they have become more challenged in the short-term for consumer facing areas of technology, like e-commerce and fintech,” he says.
Although the market is currently looking past fundamental strength within the technology sector, the long-term value proposition of the stocks remains unchanged, says Mr Kim, agreeing with Fidelity’s Mr Guinness that the multi-year transformations we are seeing will persist over the long-term.
Healthtech
One area which is continuing to see considerable innovation is healthcare, says Erin Xie, lead portfolio manager of the BGF Next Generation Health Care Fund. Telemedicine was underway well before the pandemic, though Covid accelerated its adoption out of necessity. “We anticipate a durable behavioural shift with certain appointments, like prescription consultations, occurring virtually,” she says.
Elsewhere, Ms Xie foresees innovation in medical devices, from precision surgical tools and minimally invasive procedures, to wearable tech and connected devices such as continuous glucose monitoring systems.
“We also see AI and software innovations in electronic records, insurance plans, and next-generation healthcare providers. Likewise, machine learning in clinical settings can serve to identify new biomarkers of disease and novel drug compounds faster than human pathologists, which should expedite the discovery of new drugs,” she adds.
The Covid crisis has shown how important companies from the biotechnology sector are when it comes to developing new drugs and vaccines, says Dallas Webb, portfolio manager at BB Biotech, in particular the way in which the novel mRNA technology was used to resounding success. This technology can be used in other ways, he explains, and can be deployed very flexibly and safely.
“This opens up a wide field of applications in various disease areas, though in the next few years, we expect most clinical advances to be related to other infectious diseases,” says Mr Webb. “In the medium to long term, however, mRNA therapies may also play an increasing role in the treatment of cancer and hereditary metabolic diseases. Investor attention has been correspondingly high, and a lot of money has flowed into the sector.”
In addition, AI developments in the biotech sector have been steadily gaining momentum for about a decade now, he reports. Advanced analytics, artificial intelligence and machine learning approaches are being applied to tasks ranging from target identification to drug discovery and candidate selection, all the way to better trial design and patient selection.
“The dynamic pace of change across the entire spectrum of computer science coupled with high levels of innovation within the field of AI/machine learning are fuelling this strong momentum. Innovative advances in areas of the overall R&D process can be regarded as early indicators of a successful treatment approach further down the road,” adds Mr Webb.
Looking past the pioneers
The recently launched TB Amati Strategic Innovation Fund is set up around the premise that innovation is complex and can therefore be mispriced. The fund also does not limit itself to the pioneers in a particular technology, which may be immature businesses which are not yet profitable, but is also interested in what it terms the enablers and adopters of that technology.
Co-manager Graeme Bencke gives the example of electric vehicles. “Everyone is familiar with Tesla, it is the pioneer in this space but it is taking on a huge amount of binary risk with a lot of potential reward, but also a very uncertain future.”
So it may therefore be better, he argues, to look towards the enablers. Mr Bencke gives the example of Infineon, a company that supplies semiconductors to the automotive industry, which could experience similar levels of growth but without the binary risk.
“And then, going beyond that, we have the adopters, companies like Volkswagen that can take a lot of the innovation and the ideas that are coming out of the pioneers and enhance and augment their own products in order to grow sales.”
Taking the different natures of these pioneers, enablers, and adopters, each with different risk-reward profiles, means a portfolio constructed using combination of these three different categories, should, in theory, mean a more balanced ride for investors, he argues.
From quant to AI investing
While many funds have invested in artificial intelligence companies, some are using the technology to run the portfolios themselves.
One such fund is run by Vescore, part of Vontobel. Vescore has long been a pioneer for quant investing and the move to AI is a “natural evolution”, says its head of portfolio management, Stephan Schneider.
“The most important thing in both quant and AI investing is data,” he explains. The quality and quantity of data is improving all the time, says Mr Schneider, making this kind of investing possible.
One technique the fund uses is to look for periods in time with similar economic similarities to today, which he calls the “economic neighbours”, to give guidance as how best to construct the portfolio.
The firm developed its own AI in-house, largely using the same personnel which developed its quant models.
Are investors ready for this approach? “They are becoming much more familiar with AI from its use in their everyday lives, but it is very important that they have an understanding about what the fund is doing,” says Mr Schneider.
“It is the same with quant investing, investors don’t want to just see a ‘black box’ running things. But I like to think that what we do here is very easy to understand.”
VIEW FROM MORNINGSTAR: US mega-caps dominate tech space
The dominance of US technology and growth stocks has led market returns over the last decade. In light of this, we can place spotlight on the “Faang” stocks, which encompasses Apple, Amazon, Netflix, and Google (now known as Alphabet).
The rebranding of Facebook and Google, and Netflix’s smaller market capitalisation compared with the rest of the group — which meant the streaming company was no longer a poster child — brought about the acronym Mamata, which also captures Tesla and Microsoft, given their increasing dominance in the US market. The Mamata group, formed by the six largest stocks in the S&P 500 — Microsoft, Apple, Meta, Alphabet, Tesla, and Amazon — had a combined weight of 24 per cent in the S&P 500 and 42 per cent in the US growth index, Russell 1000 Growth, as of February 28, 2022.
The Mamata group has been responsible for a significant portion of the US market’s gains. Over the past five years, Mamata stocks have accounted for one third of the S&P 500’s performance and half of the Russell 1000 Growth Index’s returns. Although these companies have steadily risen, the pandemic accelerated this, with tech names being clear beneficiaries of the work-and shop-from-home-environment.
These companies profited from demand for e-commerce, digital advertising, and cloud computing services, which, in turn, boosted their share prices, increasing their market cap and their weight in the US indexes.
Apple and Microsoft alone accounted for 21 per cent and 30 per cent of the S&P 500’s and Russell 1000 Growth Index’s performance, respectively, over five years to end-February 2022.
Tesla was only added to the S&P 500 in December 2020, but its market value skyrocketed, having returned a cumulative 1515 per cent in sterling terms over the last five years to end-February 2022. The electric car company has benefited from an accelerated shift toward green and more sustainable forms of energy.
Record concentration means the S&P 500 has never been more dependent on the continued strengths of its largest constituents. On the flip side, it is more susceptible if mega-cap names sell off sharply. While this is not new and investors in US equities have faced the issue of managing their funds against ever-consolidating US indexes for many years, the situation is at the extreme right now.
The concentration risk is even greater in the growth benchmark, as Mamata stocks reach historical highs. The UCITS 10/40 rule — which means no more than 10 per cent can be invested in a stock — makes it impossible for most large-growth funds to even hold Apple or Microsoft stocks at their current market weightings (12.3 per cent and 10.8 per cent, respectively), let alone overweight them.
In turn, we have seen the same phenomenon play out in the global equities market, albeit to a lesser extent. Mamata dominance has led to a concentration of their exposure in the MSCI World Index at nearly 12.7 per cent as of February 28 2022.
Lena Tsymbaluk, senior manager research analyst at Morningstar
