Share sector review – technology

What is the technology sector?

‘Tech’, ‘technology stocks’, ‘big tech’ – and everything in between, probably aren’t new phrases if you’ve read the business news in recent years.

But what is the tech sector?

Broadly, it includes businesses that sell goods and services related to computers and/or software. From physical equipment like personal electronics, to the chips that make them work. From social media platforms to the computer applications that host them. It spans a huge universe.

How has the technology sector performed?

Past performance isn’t a guide to the future. Source: Refinitiv Eikon, global tech index 04/09/18 to 04/09/23.

The last few years have lit a fire underneath the tech sector. Mainly caused by the pandemic, companies and entire societies had to accelerate their digital transformations, which has clear benefits for tech companies. This is especially true for companies that specialise in cloud computing.

More recent changes have been triggered by the huge progress and excitement in AI. The speed at which AI adoption has taken hold has really caught the market by surprise.

The dips we saw in 2022 were largely triggered by rising interest rates and inflation. Higher interest rates make investing in more highly valued stocks (like tech) less attractive. That’s partly because the returns available on cash savings are higher than before, meaning people are less inclined to take the risk of investing.

Where are the biggest opportunities?

Chip manufacturers

We still think that certain chip manufacturers have potential. Ones that are more focused on AI applications are exciting. But we’re also aware some more hardware-focused chip makers are pivoting their offerings to try and muscle in on some AI market share.

There could be upside potential here, but they’re riskier. We should note that tensions with China are increasing, which could affect trade with the region too. For now, this isn’t too much of a problem, but this could change at short notice.

Software as a service and cloud computing

We’re also supportive of companies with software as a service (SaaS) model instead of selling physical goods. Established software companies tend to have higher margins than others, because while building the infrastructure is expensive, once that’s done, adding an extra customer doesn’t cost much.

Within this, cloud computing has huge potential. This can cover everything from providing the firepower to get AI products off the ground, to cybersecurity and everything in between.

Automation

Zooming out even wider, a growing and long-term growth trend is automation, which has very close links to AI. This presents a long investment runway. In other words, we think spending on this area will carry on for some time. This is a core area for the new age of tech.

Cybersecurity

Another trend to be aware of is cybersecurity. Bubbling geopolitical tensions have increased attention on this area, and we struggle to see anything changing that soon. We think security will remain a very high priority for the foreseeable future.

Companies with deep pockets and existing customer trust in the world of cloud security solutions stand to benefit the most from this trend.

Healthcare

An area you might not immediately associate with tech is healthcare, but, in our opinion, this industry is primed to generated growth closely linked to tech.

As tech companies look to find new sources of revenue, they’re hunting for industries ripe for transformation. Healthcare is one such arena. Many new-fangled diagnostics and treatments will be rooted in tech and AI in the future. In the grand scheme of things, changes are in their infancy, but we think this is something to monitor.

What are the risks?

We’ve seen some company valuations shoot through the roof thanks to the AI boom. While that’s a sign of positivity from the market, it increases the risk of ups and downs. Always remember, price is what you pay, value is what you get.

There’s growing hope that the Federal Reserve (Fed) is done, or at least almost done, with increasing interest rates. On a macro-level, this should help underpin interest in tech stocks.

But at the same time, there are questions whether the market’s too optimistic about the Fed’s plans. This could lead to shocks if rate hikes are different than expected.

Looking at the companies themselves, there are things to keep in mind. Margins are coming under pressure as tech companies have to spend in order to develop new products, and broader inflation and supply issues are adding to costs too. And it’s a very tough fight for top technical talent.

Linked to this is competition. It’s still too early to say who’ll win the AI arms race. Just because someone is a front runner now doesn’t mean they’ll always be. For example, AOL used to be the go-to search engine and Skype had a stronghold on video-calling before it went mainstream.

It's also important to monitor spending patterns from tech’s main customers. In many cases these are advertisers, and in the case of a recession, we expect demand to weaken.

But for big AI and cloud players, their main corporate customers are currently having to strike a balance between spending big to innovate and future-proof, and keeping costs down as economies cool. Exactly how demand maps out will have short-to-medium term implications for tech company valuations.

Regulatory risk is a genuine hurdle that we can’t ignore. Whether that’s fines relating to privacy or competition failures, to being blocked from acquiring other companies, regulatory action is part and parcel of the tech world. A company’s ability to stomach financial, operational, and reputational reprimands need to be considered carefully.

Our view

The tech sector houses some of the biggest opportunities around today. But in that there are also some increased risks compared to other corners of the market.

Part of this is also not being swayed to follow a crowd. Rapidly rising or falling share prices can make you feel like you need to act. Even though it can be difficult, investors should remember to take a breath and work out their real reasons for deciding to trade.

Financial strength is paramount. Evidence of operating profit growth and free cash flow generation are really important. It means the company has a backbone to help support it in difficult times. As always, there are no guarantees.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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