The IT sector has been a very rewarding investment opportunity for many years, even when you include the technology crash of 2000. Especially when considering the strong performance of the sector in 2017, it might be worthwhile to take a step back to find out whether the tech frenzy is overdone or not. Is the current market capitalization of the technology sector out of sync with the underlying reality?
It is clear to everyone that technology is evolving constantly and that it is impacting our daily lives more and more. Think simply about your smartphone, with all the apps you are using every day, or about how artificial intelligence helps prevent credit card fraud, and the way advanced sensors and cameras increase the safety aspect of car driving. Most technology has improved our working and living habits. This is, in our opinion, the final goal of every single technological innovation: to improve the quality of our lives.
In recent years, we have observed a panoply of new technologies and applications coming to the market, ranging from Internet of Things (IoT), autonomous driving and Virtual Reality (VR) to robo-assisted surgery, Big Data, and Artificial Intelligence (AI). The reason why all these applications are coming to the market only now is the current, almost unlimited, availability of computing power and storage. It is only at this very moment that every sector, every company, every department within every company, and every individual are really feeling the impact of this technological revolution. All of a sudden, the end market for IT is growing dramatically and will continue to do so. This is essentially the main argument behind our long-term positivism on the sector.
The key question today is whether these secular trends have been completely discounted in the current stock prices or not. Seasoned investors will automatically refer to the burst of the IT bubble in March 2000. They will remember high valuations, undisciplined capex spending and soaring revenue growth expectations for years in a row. This was all sparked by the advent of the World Wide Web and many investors overlooking traditional concepts like valuation, leverage or risk. It was only about not missing the internet boat and the related supply chain. Unsurprisingly, the total market capitalization of the IT sector compared to the total market more than tripled in only 5 years (fig. 1). No need to recall what happened when many of these dot-coms ran out of money, as they were not able to deliver on their lofty promises with regard to the profitability of their respective business models.
We are convinced that we are nowhere near a Y2K scenario. The sector has learned its lesson and completely reinvented itself. The massive consolidation that took place in the aftermath of 2000 is still ongoing, e.g., in the memory semiconductor space, the number of important players has gone from around 25 to 3. The impact on the profitability of the remaining companies is easy to understand.
Classic metrics such as P/E, operating margins and expected revenue growth are all much more realistic and far removed from year 2000 levels (fig. 2). In the table below, we compare data for the aggregated semiconductor industry as a proxy for the total IT sector.
Last, but not least, the weighting of the IT sector in the total US equity market has gone up gradually (still way below year 2000 levels) but, this time around, the earnings evolution of the sector has increased much more. On a 20-year horizon, the IT sector’s weighting has tripled, while earnings have increased more than ninefold.
The unrivalled innovation taking place in technology is far from over. Completely autonomous cars or advanced drones that will deliver your ordered goods without any human intervention, or quantum computers that will be millions of times more powerful than the latest computers, and mini-robots that can be used inside the human body – performing tissue biopsies and dispensing drugs – are but a few examples indicating that we are still in the early innings of what will be possible in the future. This technological evolution will continue to drive the revenues, margins and cash generation of the IT sector in general. We consider the current valuation to be fair, but cannot exclude a temporary correction, given the significant outperformance, especially in 2017. At the same time, we remain convinced that the sector continues to deserve investors’ attention and remains an attractive investment opportunity, given the numerous secular drivers.