There is mounting evidence to suggest that technology-driven profitability will produce a new instruction manual in the coming years. Active management and a global perspective can be essential. At least that is what Trevor Noren, thematic investment strategist at the investment fund manager Wellington Management, considers, according to a report to which ‘La Información’ has had access.
After a resounding flop in third-quarter results, US social media shares lost as much as $47 billion in a single day. Overall, many noted the drop was attributed to transitory factors to a lackluster digital ad market.
The question is, has the profit peak been passed for social media companies? Optimists believe that current social media profitability is the result of primarily cyclical factors and that the secular case for growth holds (albeit at below-historic levels).
Although cyclical factors are certainly a challenge, we may have seen earnings peak for all of these companies and they are unlikely to grow (much) in the future… In other words, this may now be a mature market with characteristics similar to commodities, according to Wellington Management.
“To be clear, there is no internal consensus on the future trajectory of stocks for social media companies or the tech sector in general,” says Noren. However, his analysis raises a question worth considering for all investors: the future?
“Bet on the growth of big technology” has been the motto that has defined the investment regime after the global financial crisis. In 2011, the five largest companies in the S&P 500 Index accounted for just over 10% of the index’s total market capitalization. Last year, Apple, Amazon, Microsoft, Alphabet and Meta accounted for more than 24% of the indicator’s weight.
Will this dominance of profitability continue in this new inflationary regime? “There is increasing evidence, both cyclical and structural, that the answer is probably no,” the expert deepens. “In social media, entertainment, e-commerce, and even cloud storage, the digital giants have arguably reached a point of maturity that could lead to slowing growth rates and much, if not more, macroeconomic connection.” , wield the expert.
The technological silent war
Meanwhile, rising US-China tensions could dent profits for US tech companies with revenue or manufacturing capacity located in China. Also, as the entity explains in the report, it would be likely that consumer-oriented digital business models -that is, many of today’s largest digital natives- obtain worse results than business models oriented to companies of face to the future
“According to estimates by the International Data Corporation, the global ‘datasphere’ is about to double in size between 2022 and 2026, and the business datasphere will grow more than twice as fast as the consumer datasphere,” Noren points out.
To be sure, investor caution towards all US tech stocks remains justified. We see signs that investors remain somewhat complacent about the potential for underperformance in US stocks, given historically high valuations relative to international equity markets.
“In our investment diagnosis, we also saw a growing conviction that some technology companies, both private and public, were soon going to offer attractive entry points,” Noren points out. Maximizing these opportunities will likely enhance an active approach and global perspective, leveraging deep fundamental research to identify growth drivers, recession resilience, and timing to act on one’s convictions, as outlined.
The paradigm shift
Throughout 2022, extreme macroeconomic uncertainty has sometimes caused indiscriminate selling in the markets by sectors, factors and countries. These sales have neglected the idiosyncratic dynamics of each company, which will determine long-term profitability. In his view, when it comes to technology, it’s not too early to formulate a how-to manual for capitalizing when profitable price disconnects inevitably arise.
A Gartner projection suggests that by 2023 global spending on information technology (IT) will grow by 5.1%, reaching $4.6 trillion. Thus, Jeff Wantman, global analyst of the sector, believes that this resistance is already evident in the perspectives communicated by software companies. “In this, from a high-level perspective, the overall demand levels are mixed – no one was making sense of crashes in any way,” says Noren.
Several companies are experiencing delays, longer deal approval processes, and a higher number of approvals needed to get through. That being said, many other companies are not seeing significant changes to their growth trajectories. Almost unanimously, everyone stated that the project portfolio was healthy. “IT is the last and hardest thing to cut when you’re in a labor-constrained environment,” the expert adds.
“We are aware that a recession is likely, we are aware that budgets are likely to be reduced, but this is an item that in most cases – especially for large companies – you cannot cut too much” , given.
Angel Pan, a research associate at Wellington Management, echoed this sentiment in a note summarizing her updated view on automation values. Few technology sectors have tailwinds as clear and powerful as industrial automation.
According to McKinsey’s calculations, approximately 480 billion of the 750 billion labor hours spent in manufacturing-related activities worldwide are automatable with existing technologies.
Aging demographics, decarbonization, and deglobalization are megatrends that could incentivize companies to accelerate automation efforts to achieve efficiencies that save labor and emissions. “However, between the slowdown in global growth and high valuations, it now seems too early to act,” says the entity.
Since cycle highs, most automation values have fallen by 30-40%. However, falling orders and profit cuts have only just begun. “I don’t think this is the time to increase exposure to the sector in general…”, says Pan.
The magnitude of the correction we have seen in the sector so far is approaching what happened in the 2015 and 2018 down cycles and 20% as further profit cuts are anticipated, according to Pan.
“If you look at valuation – whether from an absolute or relative perspective – on average, we’re also still at the high end of the 20-year range…While we haven’t turned positive on the sector as a whole yet, we believe that it’s time to start tuning and adjusting as stocks will rally before the last order cut (and well before the last profit cut), and this is a sector where I think portfolio managers can look for exposure in the long term due to its attractive structural tailwinds”, he concludes.
