Markets & Research
Overachieving technology stocks catch their breath

For the last decade, technology stocks have been nothing short of dazzling. The S&P 500 information technology index has leapt 20% annually over the past decade, more than quintupling in value over that time. And the index vaulted a stunning 74% in the last 12 months as the COVID-19 pandemic channeled millions into online work and play.

Not surprisingly, some of the most notable returns came from the descriptively named FAANGs — Facebook, Apple, Amazon, Netflix and Google (represented by its parent company, Alphabet). The mnemonic is a bit misleading, as Microsoft is usually classified with this group. Five of the six stocks handily beat the tech index in the last 10 years. The exception is Facebook, but only because it didn’t go public until 2012; since then, it’s also topped the sector.

So when technology companies endured a mid-February falloff, it raised eyebrows. The tech-heavy Nasdaq tumbled just over 10%, bottoming out in early March and bobbing upward to end the quarter 6% off its highs. Were tech prices artificially high? Was this a bad omen as vaccination efforts allowed people to leave their homes and venture back to the wider world?

The answer, says Max Sasso, a Capital Group Private Client Services portfolio specialist, is that even dominant industries take the occasional breather.

Despite pausing, tech stocks edged up in the quarter

Line chart depicts annualized U.S. consumer spending on pleasure boats from 2008 through February 2021. The chart shows a sharp decline from around $16 billion in early 2008 to $10 billion in mid-2009. Spending reached a low of $9 billion in December 2010. From there it generally rose, with some volatility, and reached $19 billion in November 2019. From February to April 2020, spending dropped from $18.7 billion to $14.1 billion. By June 2020 it had soared to $24.3 billion. It then reached its high point for the data set of $26.1 billion in January 2021, then fell to $24.9 billion in February 2021. The chart also shows recession periods, as determined by the National Bureau of Economic Research, from January 2008 to May 2009, and from February 2020 through February 2021. Source: Bureau of Economic Analysis, Refinitiv Datastream. As of February 28, 2021.

“Tech is just paused,” he says. “It’s more about what’s happening with other sectors and industries of the broader markets that were adversely impacted by the pandemic crisis. Energy and financial companies are up significantly for the year. So it’s really those that have done well.

“While tech has pulled back from its year-to-date highs,” Sasso says, “the Nasdaq index is still up for the year, as are most of the FAANGs.”

Tech businesses have to be evaluated in many ways.

Investing in tech often means finding a comfortable balance between high valuations and appealing long-term potential, notes Greg Fuss, a Capital Group Private Client Services equity portfolio manager.

“There is a worry that many tech stocks have gotten fairly expensive, and in some cases based on little or no profits,” Fuss cautions. Still, “many of the FAANGs and related companies are very special assets. In many cases, I’ve been content to maintain a fairly full position, understanding that there are going to be times when the market turns its attention elsewhere for a while.”

Many tech companies deal in intangibles — networking, software services, advertising and the like. Even the plethora of delivery services steer clear of actual pickups and dropoffs, acting more as go-betweens and payment processors for independent contractors and hungry consumers. Actual delivery costs tend to be low.

That kind of business model can help a company grow rapidly, Fuss says, “particularly once they get a critical mass of customers. And ideally, they have the ‘network effect’ where their product gets more valuable as more people use it. Companies that meet these criteria are rare, so you’re going to pay more for them.”

A key question in such cases is how big the eventual market might be. “We estimate how much customers need the service, and the likelihood that competitors can take market share or make it difficult to control pricing,” Fuss says. “All these things go into the dream. You kind of know too expensive when you see it.”

Even some dominant tech behemoths may have plenty of room to expand. For example, Amazon has been referred to as “the new Walmart,” Sasso says. “Yet Amazon and other online retailers are still just a fraction of overall retail sales.”

Online activity totals 14.3% of U.S. retail sales. That’s only about one in seven dollars spent by consumers on items like food, clothing and gadgets — meaning even big online sellers have a long runway yet.

It’s essential to see through short-term noise.

“When our portfolio managers and analysts invest in technology companies — really, any company they choose to invest in — they’re acting on their beliefs, on their highest convictions,” Sasso says. “While every portfolio manager and analyst has their own set of criteria, our long-term orientation allows us to navigate through short-term randomness.”

Many traditional criteria are valuable to evaluating digital businesses. For example, the width of a company’s moat — that is, how difficult it is for new competition to enter that field and siphon off customers — is a common consideration, Fuss explains. And as intangible as it sounds, management is also critical.

“They must be able to navigate the inevitable curveballs that are thrown along the way,” he says.

“Our long-term orientation enables us to monitor management’s ability to deliver on the strategies they’ve laid out,” Sasso adds. “The focus is not necessarily on what their earnings were for any one quarter, but whether they’re progressing on their stated plans.”

This recent tech blip is likely a fluctuation.

The recent tech softness came amid a surge in the financials and energy sectors. Both suffered during the COVID-19 pandemic and have picked up steam this year as optimism has grown around vaccination efforts. Energy climbed nearly 30% in the first quarter, and financials 15%.

“The tech stocks that benefited before are now disadvantaged in the short run,” Fuss says. “Companies that were hard hit in the pandemic are rebounding.”

But, he stresses, that doesn’t change tech’s underlying promise. “Strong tech companies can still continue to compound their business.”

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