05 Aug 2022
Katie Koch, Chief Investment Officer of Public Equity | Brook Dane, Portfolio Manager, Fundamental Equity | Sung Cho, Portfolio Manager, Fundamental Equity
In mid-November 2021, the equity market began to pull back, driven initially by concerns about rising interest rates and higher inflation. To date, technology equities have experienced the sharpest correction, given their relatively greater sensitivity to interest rates and starting point of elevated valuations: the price-to-next twelve months earnings ratio of tech equities is down 30% since mid-November.1 We see this correction as macro-driven and largely indiscriminate: tech fundamentals remain strong, and we believe the companies in which we invest are well-positioned to potentially outperform in an inflationary environment. In our view:
Over the long term, we believe investors will prize the innovative technology companies that can offer differentiated value to their customers and help businesses do more with less. In our view, inflation will only increase demand for disruptive innovation – particularly the technologies that help businesses grow into and continuously adapt to an uncertain future.
Over the last several months, central banks’ hawkish shifts in policy in response to rising inflation have unsettled investors and triggered a broad-based repricing of equities. Since the sell-off began in mid-November, the broad equity market has fallen by 20%.2 Tech equities, which cumulatively outperformed the broad equity market by 216% over the prior ten years, have experienced the most severe sell-off, pulling back by 30%.3
Tech equities have experienced the deepest sell-off largely because they have the highest anticipated growth rates and derive the majority of their value from cash flows extending far into the future. As a result, they have the highest implied duration risk: they are the most sensitive to rising rate expectations. When the market anticipates higher rates, it applies a higher discount rate to those future cash flows, lowering their present value.
Companies are now adjusting to an environment where capital is not free, inflation is elevated and persistent, and investor appetite is transitioning from growth at any price to growth at near term profitability. At the same time, the global economy is undergoing widespread, inescapable digital transformation that is changing how corporations operate and invest to advance their business goals.
We believe that demand for innovative technology is not cyclical, but rather is deeply secular. What we have learned from thousands of conversations with company managements is that businesses, bolstered by their strong balance sheets, will continue to invest in the technologies that help them maximize efficiency. As Microsoft CEO Satya Nadella explained on a recent earnings call, “I have not seen this level of demand for automation technology to improve productivity, because in an inflationary environment, the only deflationary force is software. […] As a percentage of GDP, tech spend is, on a secular basis by the end of the decade, going to double." 4
We believe that, as we shift to the public cloud, transition toward software-as-a-service (SaaS) models, adopt digital payment methods, and build cybersecurity resilience, technology companies – particularly those offering innovative software solutions in areas such as robotic process automation and customer experience management – will help other businesses reduce costs, improve operational efficiency, identify bottlenecks, and predict dislocations before they occur. Furthermore, many of the companies offering technologies that underpin our transforming world – leading-edge chips and security solutions, for example – will command above-average pricing power. For these two primary reasons, we believe select innovative technology companies may benefit from inflation, and that the current environment presents an potentially attractive opportunity for active investment in the future technology leaders.
In today’s inflationary environment, companies will need to do more with less and identify solutions to bottlenecks and inefficiencies. We believe this will increase demand for key next-generation technology solutions. Morgan Stanley’s latest CIO Survey found that, on average, CIOs expected their technology budgets to grow by 4.5% in 2022. That is notably higher than the 10-year average of 4.1% growth.5 Software upgrades are expected to drive this increased spending, with cloud computing, cybersecurity, and digital transformation at the top of CIO priority lists. The MIT Center for Information Systems Research (CISR) recently found that companies that complete their digital transformations tend to see margins 16% higher than their industry average, bolstering the case for prioritizing this spending.6 As an example – despite experiencing inflationary pressure and cutting its FY22 earnings per share guidance as a result – Bath & Body Works is accelerating its IT investments: on its latest earnings call, the CEO spoke about investing to “transform [Bath & Body Works] into a data-driven organization, which will allow [it] to further strengthen [its] customer connection and capture new market opportunities.”7
One potential solution for companies is investment in automation software. As labor costs increase, companies will look for ways to automate the simplest, most repetitive tasks using technologies such as robotic process automation (RPA). RPA can free up employees to focus on higher value-add tasks, resulting in increased labor productivity and lower overall costs. For example, attended and unattended robots may help save thousands of manual hours by reducing the time needed to collect, process, and analyze data, thereby driving millions in savings in operating expenses. And automating manual and time-intensive processes – for example, those used in call centers – frees up employees to dedicate more time to deepening relationships with key customers.
Exhibit 1: Where Organizations Are Looking to Implement Robotic Process Automation (RPA)
Cowen Research has found that corporations largely use RPA to increase productivity, integrate data, and improve customer experiences. Data collection and data processing – business functions on which workers spend approximately one-third of their time in the U.S. – are a great fit for RPA processes and could result in cost savings of ~$1.96 trillion.
Source: Cowen Research RPA Survey, April 2021
The current inflationary environment has proven especially challenging for small- and medium-sized enterprises (SMEs), as they often lack the time, budget, and technical teams to connect to their customers, increase their office productivity, and drive revenue expansion. Cloud-based marketing and sales solutions can provide clear visibility to SMEs across the customer journey and highlight tangible catalysts to business growth. We believe these solutions can quickly increase SMEs’ traffic and contract value and decrease customer churn.
Technology solutions are also an instrumental part of perfecting experience management so that companies can retain top employees and customers as well as acquire new ones. Digital products and services can help companies navigate inflation, acquire new talent, and make timely and effective decisions. International Data Corporation (IDC)’s 2021 Future of Customers and Consumers survey shows that purposefully applying a customer-first approach to technology spending results in companies seeing a higher return from their digital transformation investments. The majority of those that reported the highest returns on IT spending (9x-12x) made customer experience (CX) improvement their top priority.8
Demand for truly innovative products and services is often less discretionary, and therefore more inelastic, than it is for traditional goods and services. Cybersecurity solutions are a key example of this. Cyberattacks can have devastating financial and reputational impacts on companies, and to avoid these potential shocks, companies are increasingly relying on advanced solutions to secure their data. As attacks become more sophisticated, cloud migration weakens traditional perimeter network defenses, and the proliferation of data sharing across geographies opens up new vulnerabilities, companies will have no choice but to upgrade their systems to be more resilient to complex attacks. Beyond that, companies are proactively seeking innovative products: one such example is a new technology that resolves cyberattacks in real time, across network, endpoint, and cloud. The company that developed this product has been able to pass on cost increases to its end customers – while continuing to see accelerating demand – due to the quality of its innovation. Innovative product offerings and upselling to customers have generally been driving gross margin gains and strong operating leverage in the industry.9
Exhibit 2: Budget Growth in Security vs. Overall Software
Source: AlphaWise, Morgan Stanley Research, January 2022
Selling last year’s products at higher prices can be tough, but if companies can innovate to improve their products and services, consumers may be more willing to pay a higher price for these new features and benefits. The semiconductor companies in which we seek to invest provide examples of such robust pricing power. We aim to invest primarily in the “picks and shovels” companies providing innovative solutions for the 5G, industrial, and automotive end markets: the semiconductor equipment manufacturers developing products directly aligned with cloud migration, vehicle electrification, factory automation, intelligent agribusiness, and the buildout of renewable energy infrastructure – all of which we believe are in the very early innings of growth. Despite input cost increases, select semiconductor companies have seen accelerating – and even record-level – gross margins, due to a combination of the superior quality of their product design and their increased manufacturing efficiency. These companies have been able to pass on cost increases to their customers, who are locked into long-term agreements, for innovative products including intelligent power and sensing for warehouse automation, autonomous vehicles and delivery robots, and smart agriculture; silicon carbide power devices for electric vehicles; high performance power management; and custom silicon for enterprise applications, among others. We believe the semiconductor industry will transition from mid-single-digit growth to high-single-digit growth over the next five years, with pricing flat to up due to consolidation and greater pricing power and content expected to rise meaningfully – with, for instance, electric vehicles requiring roughly three times more chip content than traditional internal combustion engine vehicles. The need for more content (per server, per car, per data center, etc.) and more innovation is insatiable, and we believe that the semiconductor companies providing differentiated value to their customers will see sustained demand as the world continues to digitize.
Exhibit 3: Semiconductor Gross and Operating Margins
Jefferies Research forecasts that median gross and operating margins for semiconductor companies will continue increasing through 2022.
Source: Jefferies Research, May 2022
We believe the market has underestimated the tailwinds that a new inflationary regime will provide to select technology companies – those that either are focused on helping other companies mitigate the effects of rising costs or have pricing power due to the quality of their innovation. This underestimation can be partly explained by how traditional accounting methods do not fully capture the value of intangible investments – those made not in physical assets such as factories but in intangible ones such as software. Research and development – the engine of innovation – is expensed instead of capitalized, and there is virtually no accounting disclosure of the quality of a given company’s R&D.10 It is our view that this is where the power of active management comes in: as long-term-focused active, fundamental investors, we are able to take a deep dive into the quality of tech companies’ innovation and invest selectively in those we believe are underpriced today and will win over the long term.
Whereas investing in private markets offers access to more nascent technological innovations – which often create entirely new markets – investing in public equities offers complementary exposure to technological innovation in areas with higher capital intensity, more extensive regulation, and less binary risk. For example, public market investors can gain targeted exposure to a capital intensive part of the tech universe: semiconductor capital equipment companies, which we believe may benefit from broad-based moves to reshore semi supply chains and intensifying competition between the key leading-edge players. Investors can also gain exposure to towers – subject to far-reaching telecommunications regulation and primarily accessible to investors through publicly-traded REITs11 – which we believe may also benefit from our increased reliance on data infrastructure. In software, private companies tend to be subject to more binary risk than we see in the public market. By the time most tech companies come to the public market, they have validated their product-market fit, and much of the business model and technical risk has by extension been reduced. We see this in many high-growth software companies, whose largest customers are spending at significantly higher rates than the broad customer group – and as a result are driving significant portions of total company growth
In addition to having discounted valuations relative to private companies, public companies are less sensitive to rising rates, with between 70%12 and 90%13 of their debt outstanding being fixed-rate. In the case of private companies, by contrast, only about 30% of debt outstanding is fixed-rate. Public companies will eventually experience the impact from rates when they have to roll over their fixed-rate debt, but the maturity profile of most of their debt is over three years – with the dollar-weighted debt maturity for small caps at six years and large caps at eight years. We believe that, for these key reasons, investing in public tech equities can potentially provide investors complementary exposure to private market innovation within their portfolios.
While uncertainty and the resulting market volatility are likely to persist for some time, one thing is for sure: uncertainty and volatility drive increased differentiation between stocks, making active management critical. We believe the current environment also heightens the need for active managers to: 1) be selective, using a disciplined, fundamental approach; and 2) build well-balanced portfolios aligned with durable, secular growth themes.
It is important to remember that not all technology companies are created equal. Businesses with robust balance sheets, high profit margins, strong free cash flow, and low leverage tend to be best positioned to withstand higher interest rates and rising cost pressures. One of the metrics we pay close attention to is a company’s gross margin, which usually indicates a cushion to absorb inflation, strong pricing power, and core unit profitability. Furthermore, we are careful to differentiate between companies that may be unprofitable now but are likely to become profitable in the future, and those that may never become profitable. We believe that unprofitable companies that do make it into a tech allocation should have a very clear path to profitability, characterized by accelerating growth, high recurring revenues, excellent gross margins and net cash balance sheets.
In addition to being selective at the stock level, we believe it is important to build well-balanced portfolios. We invest globally and across market capitalizations, allowing us to be nimble as relative risk/reward opportunities change; for example, if valuations become stretched in one part of the market, we can move capital elsewhere. To that end, we also believe that allocating to both growth- and value-oriented companies – for example, high-growth software companies and semiconductor capital equipment companies – helps investors to manage their factor exposure.
History suggests that investing in technological innovation and disruption is a winning strategy. Over the last 10 years, the companies we define as disruptors have outperformed those that are vulnerable to being disrupted by 411%.14 52% of the companies that were part of the S&P 500 30 years ago no longer exist,15 as a result of both acquisitions and disruption. At present, we believe that over 70% of the companies in the S&P 500 could be at risk of being disrupted, creating potential opportunities for innovative enterprises to generate meaningful value over the long term. It is therefore critically important for investors to look beyond market-capitalization-weighted benchmarks, which allocate too much capital to the past winners and potentially leave investors underexposed to the winners of the future.
We focus on leaning into long-term secular growth themes such as digitization and tech-enabled consumption to invest in the most innovative technology companies, no matter their size or country of origin. Going forward, we believe that tech fundamentals will remain robust – against a backdrop of strong corporate and consumer balance sheets – and that demand will continue to grow as the world continues to digitize. In a world where growth is increasingly scarce, we believe that the tech winners whose growth is fueled by anticipating and responding to the challenges companies are facing across sectors will be the most valuable, and over the long term will be priced accordingly by the public market. We seek to position our clients on the right side of disruption by investing in the technology leaders of tomorrow.
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