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Technology & Innovation
Expectations and interest rates clipped tech’s wings
Julien Gaertner
Equity Investment Analyst

After a decade as the dominant force powering the market higher, technology stocks have been pounded this year. For some tech-focused industries, the rout has been one of the worst on record. It’s even drawn scattered comparisons to the dot-com meltdown of 20 years ago, when investors’ fixation on the burgeoning digital universe shattered as companies couldn’t live up to fantastical visions of growth.


I believe the situation today is vastly different. The issues that have recently tripped up the industry are notable and important to understand, but I think they’re temporary and can be overcome. In fact, I feel this is one of the most interesting investing environments I’ve seen in a long time.


My excitement springs from the two broad dynamics that lie behind the downturn. First, higher interest rates have reduced valuations for all stocks, but especially tech stocks, which are often sensitive to rising rates. Second, some industries and companies were simply overvalued, either because market assumptions didn’t bear out or because underlying conditions changed.


These dislocations create opportunity — specifically, the chance to invest in promising companies at suddenly more attractive prices. Selectivity and deep research are essential to distinguish companies with durable business models from those with inferior technology, fuzzy market demand or well-heeled rivals.


That’s what my fellow analysts and I do. We assess how the world has changed and how it could affect stocks. And with valuations having fallen, I’m finding what I believe to be extremely attractive investment opportunities.


Not all tech stocks have fallen in the same way.


A key dynamic in today’s market is the impact of higher interest rates. The Federal Reserve has raised rates dramatically, and that’s predictably caused all valuations to fall. Tech stocks can be especially sensitive to rates because so many of them are what we call “long-duration assets.” Basically, that means that most of a business’s value lies far in the future.


Consider Amazon. The retail giant was founded in 1995 but didn’t turn its first quarterly profit until 2001. Rapidly growing companies can take years to generate free cash flow — that is, revenue above and beyond capital and operating expenditures. Given that such companies don‘t have current earnings, the value of these stocks is, by definition, based on what they’re expected to earn in the future. Compare that to companies with lower growth rates but stable and current revenue and profit margins. Their value is derived from their growth potential as well as what they’re earning today. Higher interest rates discount future earnings more heavily than present earnings, and this tends to disproportionately compress tech valuations.


A second point is equally important. Parts of the technology industry appear to be much weaker today than expected a year ago. Some were simply overvalued: Companies whose products seemed to be tailor-made for a pandemic world, such as videoconferencing platforms or digital exercise equipment, soared in popularity during lockdowns. That led some investors to mistakenly assume that their phenomenal growth would continue. It often didn’t, and stocks tumbled as a result.


Some businesses have been hurt by industry-specific issues. For example, companies that rely heavily on digital advertising models are facing greater scrutiny from regulators and changing rules on popular platforms regarding user privacy. Meanwhile, the market is raising many questions about the maturity and competitive dynamics of the streaming industry.


These forces have led to a wide dispersion in equity valuations. Some companies are down 10%; others are down 90%. Additionally, some businesses are expanding much more quickly than expected last year, while others are growing far more slowly. That combination of massive dispersion in valuations and massive dispersion in fundamentals is exciting from a stock-picking perspective. It gives my colleagues and me a chance to apply our on-the-ground research to find companies that the market may be undervaluing.


Many tech companies look well positioned to thrive despite lower valuations.


One industry I find very attractive is enterprise software. Valuations have fallen along with the broader market, partly because many of these companies are long-duration assets whose stock prices have been hit hard by higher interest rates. The market has turned a skeptical eye toward companies reinvesting free cash flow to build up their subscription models. At maturity, software companies can be very profitable, and that makes reinvesting cash in the growth phase a sensible long-term plan for companies with good competitive positions and large end markets. Overall, fundamentals remain healthy, so the drop in valuations can present good value.


Enterprise software is expected to steadily grow for years

Enterprise software is expected to steadily grow for years. Annual revenue of the enterprise software market was $160.9 billion in 2016 and steadily grew through 2021. It is projected to continue that trajectory, growing to $344.4 billion in 2027. Source: Statista. As of June 2022.
Source: Statista. Values for 2022 and later are estimates. As of June 2022.

I’m especially drawn to infrastructure software. Society may be only halfway through a 20-year cycle in which data are migrating from local networks to the cloud. Importantly, many big enterprises are still using huge, on-premises application estates. The potential market remains significant.


Cybersecurity is another promising area. Digital risks continue to grow — including, unfortunately, the risk of a high-profile attack on critical infrastructure. Additionally, cloud usage is growing, and many well-run companies are capitalizing on that by creating platforms to help users securely access remote data.


Of course, there could be more market volatility in the near term. Inflation remains high, and rates are rising. But the short-term pressures provide an opening for investors with a long-term view. Being able to approach the market with that perspective is particularly valuable at times like this.



Julien Gaertner is an equity investment analyst at Capital Group who covers U.S. and European technology companies. He holds a bachelor’s degree from Brown University.


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