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The punchline: Mounting evidence suggests that tech-driven outperformance will require a new playbook in the years to come. Active agility and a global lens could prove to be essential edges.
Following one high-profile third-quarter earnings miss, US social media stocks lost as much as US$47 billion in value in a single day. By and large, many observers blamed transitory factors for the selloff — primarily a lackluster digital ad market.
Recently, Portfolio Manager Dan Pozen challenged this thesis with a structural question: Have we passed the point of peak profits for social media businesses? Dan then dissected key metrics that drive value creation for social media companies: user growth, time spent, ad load, and ad effectiveness.
Across all fronts, he sees reason for skepticism about how much room is left to grow. We quote Dan:
Optimists believe that current performance of the social networks is the result of mostly cyclical factors and that the secular case for growth remains (even if at lower levels than history). Stocks are priced for certain death and, therefore, represent compelling buying opportunities…While cyclical factors are certainly a nuisance, I believe we may have seen peak profits for all of these businesses and they are unlikely to grow (much) going forward… Said differently, this may now be a mature market with commodity-like characteristics.
To be clear, there is no internal consensus about the future trajectory of social media stocks or the tech sector more broadly. Nonetheless, Dan's analysis begs a question worthy of consideration by all investors: Are we at an inflection point in the digital revolution that will require a significant mindset shift about the ingredients of tech-driven outperformance moving forward?
"Bet on big tech getting bigger" has been the defining trade of the post-global financial crisis investment regime. As recently as 2011, the five biggest companies in the S&P 500 Index accounted for a bit more than 10% of the index's total market cap. By last year, Apple, Amazon, Microsoft, Alphabet, and Meta accounted for more than 24%.
Will that return dominance continue in this new inflationary regime? Mounting evidence — both cyclical and structural — increasingly suggests that the answer is likely no. Across social media, entertainment, e-commerce, and even cloud storage, digital behemoths have arguably reached a point of maturity that could result in slowing growth rates and far greater correlation with the macro environment (i.e., "commodity-like characteristics," as Dan puts it).
Meanwhile, rising US-China tensions could dent profits for US tech companies with revenue or manufacturing capacity based in China. Finally, consumer-driven digital business models — i.e., many of today's biggest digital natives — appear likely to underperform enterprise-driven business models moving forward. As the International Data Corporation has estimated, the global "datasphere" is poised to double in size between 2022 and 2026, with the enterprise datasphere growing more than twice as fast as the consumer datasphere.
Undoubtedly, investor caution toward all US tech stocks remains merited. We see evidence that investors are still dangerously complacent about the underperformance potential of US stocks given historically extreme valuations relative to international equity markets. Tech stocks appear the epicenter of that complacency. Yes, they've underperformed year to date — at the time of writing, the tech-focused Nasdaq 100 Index, a proxy for the tech sector, had fallen more than 30% in 2022 versus the S&P 500 Index's drop of roughly 20%. Yet, tech stocks still trade at a premium. As Global Industry Analyst Eunhak Bae noted: "At the peak last year, tech traded at a 50% premium to the market. Right now, we’re still at a premium to the market."
Across our investment dialogue, however, we also recognize increasing conviction that attractive entry points may come soon for some tech companies, both private and public. Maximizing these opportunities will likely require an active approach and a global lens, leveraging deep fundamental research to diagnose growth drivers, recessionary resilience, and the right timing to act on one’s convictions.
Throughout this year, extreme macro uncertainty has caused markets to at times sell indiscriminately along sector, factor, and country lines. These sell-offs have neglected the idiosyncratic company-by-company dynamics that will determine longer-term outperformance. In our view, when it comes to tech, it is not too early to formulate a playbook to capitalize when exploitable price disconnects inevitably emerge.
In a tech team meeting, Global Industry Analyst Jeff Wantman presented his key takeaways after attending a conference focused on private-market software companies. A Gartner projection suggests that in 2023, worldwide IT spending will grow 5.1%, reaching US$4.6 trillion. As Jeff writes, that resilience is already apparent in the outlook communicated by enterprise software firms at the conference:
I would say from a high-level perspective, overall demand levels are mixed — nobody was talking about meltdowns by any means. There were several who were experiencing pushouts, longer deal-approval processes, and a higher number of approvals necessary to get deals done. This said, just as many companies are not seeing meaningful changes to growth trajectories. Almost uniformly, everyone said pipelines were healthy… IT is the last and hardest thing to be cut when you’re in a labor-constrained environment. They all pointed to that as being a place where enterprises are continuing to deploy money and technology. I don’t think that’s terribly different from how I felt or how other companies I cover have talked about this also. When we’ve talked to partners or others in the community that’s generally the message: We’re aware a recession is likely coming, we’re aware that budgets are likely to get pulled, but this is just a line item that in most cases — particularly for larger enterprises — can’t be cut too much.
But stock selection and timing will prove paramount. As Eunhak summed up later in the tech team discussion: "I have a cautious long-term view on the tech sector generally. We just had a really extended period of easy money that overcapitalized the sector. You have to pick your spots…There are unique names where you can buy cheap depending on your conviction and not just what the numbers will be next year, but in 2024 and 2025."
Research Associate Angel Pan echoed this sentiment in a note encapsulating her updated view on automation stocks. Few tech sectors have as clear and powerful tailwinds as industrial automation. According to McKinsey calculations, roughly 480 billion of the 750 billion working hours spent on manufacturing-related activities worldwide are automatable with existing technologies.
Aging demographics, decarbonization, and deglobalization are all megatrends that should incentivize companies to expedite automation efforts in order to realize labor- and emissions-saving efficiencies. Yet, between slowing global growth and elevated valuations, now appears too soon to act. We quote Angel:
From cycle highs, most [automation] stocks have corrected 30% to 40%. Yet, order declines and earnings cuts are only starting. I don’t believe it’s time to add exposure to the space broadly…The magnitude of the correction we have seen in the sector so far is getting close to what happened in the 2015 and 2018 downcycles (Figure 1) and using those as guidance, we should expect another 15% to 20% downside to the sector as further earnings cuts are priced in…Looking at valuation — whether from an absolute or relative perspective — on average, we are also still toward the higher end of the 20-year range…Though I am not turning positive on the sector broadly yet, I do believe it’s time to start sharpening pencils, as stocks will rebound before the last order cut (and way before the last earnings cut), and this is a sector that I believe PMs should look to have long-term exposure to because of its attractive structural tailwinds.
Earlier this year, we quoted analysts Gregg Thomas and Noah Comen from their insight piece titled Beware of benchmark concentration. Their analysis bears repeating today: Active managers tend to allocate away from the largest names in the benchmark to source capital for high-conviction ideas.
For this to work, those high-conviction names need to outperform the largest benchmark holdings, creating an alpha hurdle. Over the past decade, that alpha hurdle has increased dramatically. To illustrate this point, Figure 2 shows the annual impact of not owning the GAFAM1 stocks for a manager benchmarked to the S&P 500 Index over the last 20 years. Notably, the last time being underweight “helped” active managers was in 2008.
Increasingly, we believe the big tech, passive playbook may now be a relic. This is a seismic shift, one many will undoubtedly resist given biases built up for more than a decade. As Equity Portfolio Manager Mark Mandel has said: "Have portfolios/allocations evolved enough from what worked in the last decade? From talking to clients, the answer is an emphatic 'no'; many are reluctant to give up on what delivered so unequivocally previously."
We expect digitization to progress, if not accelerate, across the global economy regardless of the macro environment. The new tech-driven outperformance playbook will likely rely on deep-research-driven, active management to isolate global companies with the capital discipline, management quality, and megatrend tailwinds necessary to sustain growth through elevated cyclical volatility.
The more tech sells off indiscriminately, depressing all tech valuations, the more immediate this opportunity is becoming, both in public and private markets. As Private Equity Principal Matt Witheiler wrote in his third-quarter review of late-stage private equity: “There are glimmers of hope. With each day that passes, two things are getting clearer for companies:
As these realizations sink in, prudent investors may find strategic diversification essential in their search for tech-driven alpha. This diversification could take many forms — regional, private or public market, among factors, between growth and value — and will likely be critical to successfully navigating new tech ecosystems around the world.
1“GAFAM” refers to Google, Apple, Facebook (Meta), Amazon, Microsoft.
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