The COVID-19 pandemic has represented a near-perfect storm for the world’s leading technology companies. Both earnings growth and valuation multiples have risen to extraordinary levels. Naturally, this raises questions about the sustainability of the current dynamics and the prospective risks and opportunities for investors.
The enduring case for tech
The technology sector’s strongest companies were already executing at a high level coming into 2020 — growing fast, expanding margins, and reinvesting in their value propositions. The COVID-19 pandemic has accentuated these characteristics by accelerating the need for consumers and enterprises to digitize. In addition to the COVID-19 tailwind, I think these firms deserve significant credit for their agility and decisiveness — as both attributes have allowed them to pivot quickly to capture these growth opportunities. Furthermore, I believe these companies’ unprecedented access to low-cost capital — the result of low interest rates, cash-generative business models, and their sheer size — allows for acquisitions of competitors at virtually any price. In my view, such acquisitions can serve to extend their competitive advantage periods beyond what prior technology cycles would otherwise suggest.
The combination of these factors has resulted in earnings growth well in excess of consensus expectations and valuation multiples rising to near-historic levels.
If the market has taught me one thing in recent years, it is to be humble about knowing what discount rate to apply to various businesses. Technology companies have consistently proven to be less risky than perceived, as competitive intensity has failed to disrupt incumbents. In fact, their growth and market share gains generally continue to accelerate. Likewise, interest rates have proven very difficult to predict and have frequently surprised investors (largely to the downside).
Finally, other high-quality, large-cap US companies (i.e., returns on capital, growth rates, and lack of dependence on macro variables like oil or interest rates) trade at similarly high valuation multiples. While many banks, insurers, and energy firms have performed poorly and may appear “cheap” on historical metrics, the range of potential outcomes for these sectors is wide and dependent on some unpredictable macroeconomic variables. So, while technology stocks have performed very well in recent years, their valuation discrepancy vis-à-vis the rest of the market is not always significant — particularly after factoring in differences in growth and quality.
Putting all this together, I do not think investors should necessarily expect faltering fundamentals or simple mean reversion to short-circuit the current tech regime. I was previously skeptical about these companies’ ability to maintain their growth trajectory, but I am, in some sense, a reluctant convert as technology stocks are now some of my highest-conviction ideas.
Risks to watch
At the same time, we shouldn’t be complacent following the tech sector’s significant recent growth. The prospect of a populist US administration focused on wealth redistribution (via taxes and regulation), higher inflation/interest rates down the road, and eventual normalization in other areas of the economy are just a few of the potential headwinds that could negatively impact tech companies’ growth expectations. These risks bear watching in the period ahead.
The continued growth of larger tech firms also presents a math challenge that I think should eventually become relevant. Size does ultimately challenge returns because investing hundreds of billions of dollars at adequate returns is very difficult.
Bottom line
Technology businesses and stocks have performed fabulously in recent years. The COVID-19 pandemic has accelerated this outperformance, leading many to call it a bubble. While size, valuation, and expectations should ultimately become barriers to future outperformance, I think this view may be premature. In my view, the sustainability of their competitive advantages and the underlying secular shifts favoring their demand outlooks suggest the current regime may remain in place longer than skeptics believe.
