Sector report by Maria Lomaeva, 29 January 2021
Nasdaq Composite index, S&P 500 IT index
The tech sector includes companies that carry out research, develop and/or distribute technological goods and services related to information technology (IT). Usually, the sector is divided into three segments: Software and Services; Technology Hardware and Equipment; and Semiconductors and Semiconductor Equipment.
The past year has been prolific for the tech sector, with the COVID-19 pandemic accelerating digital transformation through remote working, socially distanced entertainment, and e-commerce. The Big Tech companies have shown especially strong resilience towards the economic downturn, keeping investors’ sentiment positive which drove share prices up, together with the overall market.
Nevertheless, the pandemic has had some negative effects on the sector, such as decreased global IT spending. However, there is still a lot of investment potential as demand for areas such as cloud computing, e-commerce and AI remains high. One of the possible future risks would be a growth-to-value rotation should a successful COVID-19 vaccine drive the economic recovery. In addition, the equity market has been exhibiting an increased bubble-like behaviour which might result in a major correction, especially within the tech sector.
As two potential investments, I suggest Legal & General Cyber Security ETF (ISPY) that tracks the ISE Cyber Security UCITS Index and Xtrackers STOXX Europe 600 Technology ETF (XS8R) that follows the STOXX Europe 600 Technology Index.
OVERVIEW OF SECTOR
The tech sector consists of companies that carry out research, develop and/or distribute technological goods and services related to information technology (IT). It is highly competitive, with research and development (R&D) expenses being a large part of the cost structure, especially in the semiconductor industry. In addition, many companies operate worldwide, exposing themselves to exchange rate related risks. On the positive side, the tech sector is not as sensitive to cyclical effects as many of its products and services have become an integral part of business operations. However, the tech sector is still sensitive to economic downturns as their customers’ need and ability to purchase more products and services can decrease in a recession.
Moreover, the tech sector has one of the fastest innovation cycles (time from initiation of R&D to first customer delivery) of 0.5-5 years, with large variations within the sector: the innovation cycle for an operating system would be about five years, while for a software-as-a-service, it could be 9-24 months.
One possible way to break up the tech sector into smaller categories would be as follows:
- Software and Services
- Technology Hardware and Equipment
- Semiconductors and Semiconductor Equipment
Software and Services
This category of companies provides internet services, as well as software and IT services. Businesses that deliver internet services provide online databases or interactive services, with search engines or social media networks being an example. IT services comprise companies that offer IT consulting or data processing services to other companies. Lastly, software includes a wide range of software: enterprise software (software for businesses and governments, e.g., cybersecurity and e-commerce software), systems software (e.g., operating systems), application software (e.g., productivity suites), entertainment software (e.g., games), etc.
Cloud computing has transformed this subsector with ‘as-a-service’ (or everything-as-a-service, XaaS) offerings. Instead of purchasing a software license that would be directly installed on a PC/company server, XaaS allows customers to acquire software on a subscription basis, accessing it through the internet.
Software companies usually require a smaller capital and can on average become profitable faster than hardware and semiconductor businesses due to lower expenses needed for development and manufacturing of goods.
Company examples that offer software and services: Alphabet, Facebook, Amazon, Adobe, Microsoft and Electronic Arts (EA).
Technology Hardware and Equipment
Technology hardware and equipment is usually broken down into three industries: communications equipment (e.g., routers and telephones), technology hardware, storage and peripherals (e.g., computers, printers and mobile phones) and electronic equipment, instruments and components (e.g., electronic capacitors and resistors).
The hardware segment is dominated by a number of major players, which include Apple, Lenovo, Dell and IBM.
Semiconductors and Semiconductor Equipment
The semiconductors and semiconductor equipment segment includes companies that design and/or manufacture semiconductors (or microchips) as well as companies that produce equipment needed for chip manufacture. These microchips are later used in computers, smartphones, televisions, medical equipment, cars, etc.
Some companies own their foundries—Intel and Samsung, for example—but more commonly a chip manufacturer will create microchips for the designer company. Building a semiconductor manufacture plant bears high costs, is time consuming, and requires a cutting-edge expertise to maintain. Therefore, many companies, such as Apple and NVIDIA, order their chips from manufacturers like TSMC and Foxconn.
Another source of income within the semiconductor segment is patent licensing, which, for example, is employed by Qualcomm.
MAJOR NEWS AND EVENTS
US-China tech war
The semiconductor industry became a central part of the US-China tech war under President Trump’s administration. Lagging behind in chip design and manufacture, Chinese companies such as Huawei and SMIC heavily rely on foreign imports, which have been restricted by the US. Newly elected President Biden will almost certainly behave more predictably and diplomatically; however, he is unlikely to drastically change US relations with Beijing.
Big Tech antitrust lawsuits
During 2020, Big Tech companies Facebook, Amazon, Microsoft, Apple and Alphabet (FAMAGs) have further consolidated their dominance and driven the market upward. They are, however, facing harder headwinds from regulators around the world from the UK, EU and multiple antirust complaints from the US justice department; some antitrust lawsuits were filed specifically against Facebook, Google and Amazon. In addition, Australia now wants to restricts the advertising business of Google, which would concern Facebook as well. Interestingly, Facebook is also vocal about Apple’s anticompetitive practices due to a new privacy setting on iOS 14 operating system, while Apple claims that this decision is made to increase user integrity.
Such investigations are indeed useful to ensure healthy competition in the market and safeguard Internet users’ data privacy. The Capitol Hill insurrection in the US in January 2021, which led to the suspension of Donald Trump’s accounts on Twitter, Facebook and YouTube, also invoked questions about the power of social media platforms on free speech and disinformation. Currently there is certainly a large incentive both from the Democrats and Republicans to gain more control over Big Tech; and the Democratic Congress has already expressed such intensions. These risks are further discussed in the Fundamental Qualitative Sector Analysis section, under Risks and Uncertainties.
Recent price action
The tech sector started 2020 with a strong bull run which abruptly ended in the March 2020 sell-off due to investors’ concerns about the effects of the pandemic on the global economy. The recovery for the tech sector was, however, very rapid and in June 2020 all losses were regained. In late August 2020, the growth slowed down as the US government struggled to agree on an economic relief package and uncertainty remained ahead of the US presidential election. After the election on November 3, the growth continued.
FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS
The tech sector has shown strong resilience during the pandemic, performing significantly better than many other sectors. Growth stocks within the industry have been in high demand, driving the prices up – which is unsurprising in an environment where growth opportunities are scarce. In addition, low bond yields have created advantageous circumstances for investment in tech stocks.
Nevertheless, there have been some negative effects of the pandemic on the sector as IT spending in 2020 is estimated to total $3.6tn, which is 5.4% lower YoY.
The US tech market is the largest in the world, representing 33% of the global tech spending. Spending often depends on such factors as population, GDP and market maturity. The second biggest market is western Europe, which amounts to 19%, followed by China with 14% of global spending.
The US and China remain the two largest technology R&D spenders in the world. Total public and private science and technology expenditures in China rose 12.5% YoY to $322bn in 2019, amounting to 2.23% of GDP, 0.09 pp higher YoY. Beijing’s goal in 2020 is to reach the R&D share of 2.5% of GDP and further increase it to about 3% in 2025 ($600-650bn). The US spent 2.83% of GDP on R&D in 2018.
Potential customer base
The largest share of technology spending originates from purchases made by corporate or government entities (enterprise customers). A smaller portion stems from household spending, including home-based businesses (retail customers).
In the software subsector, enterprise customers, such as governments and small to large cap companies, rely on enterprise software (directly installed on the corporation’s servers) and ‘as a service’, or subscription-based, solutions which are a part of cloud computing.
Within Services, Big Tech companies such as Alphabet (Google’s parent company) and Facebook strongly rely on digital advertisement revenue coming from search engines and social media; their customer base consists of other businesses, often mid- and small cap. Google and Facebook-owned social media attract a wide range of users of different ages and from various socioeconomic backgrounds, which creates very favourable conditions for advertising.
Similarly to software, hardware providers deliver their products to enterprise customers (e.g., computer servers, data centres, PCs) and retail customers (PCs, smartphones, gaming consoles).
The customer base within the semiconductor industry consists of other businesses within the sector itself and hardware manufacturers.
Industry growth post COVID-19
Worldwide IT spending is expected to increase by 4% to $3.8tn in 2021 compared to the estimated $3.6tn in 2020. In this analysis, the tech sector was divided into five categories: enterprise software, data centre systems, devices, IT services and communications services.
|2019 Spending (millions of US$)||2019 Growth (%)||2020 Spending (millions of US$)||2020 Growth (%)||2021 Spending (millions of US$)||2021 Growth (%)|
|Data Centre Systems||214,911||1.0||208,292||-3.1||219,086||5.2|
In 2021, pandemic-driven demands such as remote working and virtual services are expected to drive growth of 7.2% within the enterprise software segment.
The second fastest rebound of 5.2% is expected for data centre systems as data centre expansion plans that were put on hold due to the pandemic will resume with recovering cash flows and staff being allowed back onsite. However, the enterprise cloud revenue, that increased in the work-from-home (WFH) environment, will not be reflected until 2021 because of the ‘try before you buy’ programs offered by cloud providers during the spending slowdown that occurred from April until August 2020.
The slowest recovery is expected in communication services (2.8%) and devices (4.0%) due to companies’ spending cuts in feasible areas, while redirecting the resources into the accelerated digitalisation of their businesses.
For the semiconductor industry, analysts predict a low double digit growth in 2021, while in 2020 a growth of 3-4% is excepted. The sector will continue to benefits from the 5G expansion, artificial intelligence (AI) applications, cloud computing and Internet of Things (IoT).
Despite the antitrust investigation, the Big Tech companies continued to consolidate during the pandemic and through M&A activity in 2020 and 2021, although the scale of acquisitions remains below its 2014 peak. This has raised further concerns about the widening gap between the major players and smaller companies. The semiconductor industry has seen some large M&A deals in 2020 as well.
RISKS AND UNCERTAINTIES
Vaccine and value rotation
The rotation from growth into value stocks became a subject for discussions after Pfizer’s announcement about their effective vaccine and the subsequent selloff within the tech sector. As investors have been hedging their risks with Big Tech shares during the pandemic, once the virus is taken under control, investment opportunities will lie in more cyclical stocks. The reality, however, has shown that a mere development of an effective vaccine is not enough — you also need to distribute the vaccines efficiently. The vaccination efforts have begun and are quite efficient in some countries, such as Israel and the UK; nevertheless, there are also some serious difficulties within the production and distribution of vaccines around the world, which can ultimately slow down the value rotation.
Next market bubble
In the past months, the equity market has shown high SPAC activity as well as increased volatility and irrational exuberance for certain shares, which is reminiscent of the final stages of a market bubble. The tech sector has specifically been under investors’ radar for its increased valuation which came as a result of the pandemic gains. As a result, the current situation has been widely compared to the dotcom crash in 2000. While there are some significant differences between 2000 and 2021, with many tech companies having a more solid cash flow generation and balance sheets with strong earnings, the risk of a major correction remains high.
In the current environment, interest rates play the key role for the condition of the stock market. The share prices of publicly listed growth companies, which there are plenty of within the techsector, have hugely benefitted from the record low interest rates imposed by the Federal Reserve. For now, the rates will remain low to ensure a faster economic recovery. However, if the inflation in the US significantly exceeds the 2% target, a subsequent increase of the interest rates will follow, which will probably lead to a major market correction. In the meantime, the inflation is likely to be suppressed by the high unemployment rate in the US; but those who choose to invest into tech stocks should closely monitor the condition of the market. A special attention should be paid to the assets that have recently shown particularly high price gains, such as Tesla Inc. shares and the cryptocurrency Bitcoin.
Competition and Regulation
In the US, the incentives of the political left and right to constrain the power of Big Tech differ, with the Democrats being more concerned about the spread of disinformation on social media platforms as well as anti-competitiveness of Big Tech, while the Republicans are more focused on censorship of conservative opinions online. This could potentially slow down any drastic legislation, especially considering that Democrats only have a slim majority in the Senate and the House. Regarding European initiatives, some experts believe that the UK and EU legislations are too broad and might not suit their purpose. In the meantime, the Australian initiative against Google and Facebook seems to be developing much faster, now with Google threatening to withdraw its search engine from the country. It is certainly very interesting to see how this will end and whether this precedent will set the stage for similar rulings elsewhere.
So far, investor sentiment has not been significantly affected by these developments, as reflected by the FAMAGs’ share prices. Many believe that breaking up Big Tech companies might only be a temporary solution, as the broken-up companies might grow on their own. It can also be technically difficult; in the case of Facebook, its social media platforms Facebook, Instagram and the messaging app WhatsApp all share an interconnected infrastructure which means that a breakup might linger, even up to several years for Facebook and Instagram. There are other ways for the lawmakers to limit the influence of Big Tech; for example, they could restrain future M&A deals limiting Big Tech’s entrance to new markets, or prohibit running a market, while also selling your own products on it, which would concern Amazon. In addition, to keep up with the fast-paced tech industry, Germany granted its competition regulator the right to impose restrictions on a company before the competition abuse takes place instead of having to wait until after the fact.
Without a doubt, there are considerable regulatory risks for Big Tech, however, immediate drastic legislation seems unlikely for now.
Major Market players
The largest market players within the tech sector are Apple, Alphabet, Amazon, Facebook and Microsoft, which together make up for about quarter of the S&P 500 market cap. These companies have shown strong revenue resilience during the COVID-19 outbreak which has increased investors’ sentiment and fuelled the market.
Apple was the first ever company to have reached a $2tn market cap. In the latest quarter, Apple received 59% of its revenue from iPhone sales. Apart from hardware, Apple also offers subscription services and digital advertisement, which brought in 14% of revenue (MRQ). Another 12% of the revenue came from such products as AirPods, Apple TV, Apple Watch, etc. In the US, Apple takes up 46% of the smartphone market share and 12% world-wide. However, Apple dominates the premium smartphone market segment with a 57% market share.
Alphabet (GOOG, GOOGL)
Alphabet has several lines of business but the two most lucrative ones are digital advertisement on its search engine Google and social media platform YouTube (83% of total revenue in MRQ) as well as cloud computing services (6% of total revenue in MRQ). Google has a 93% share of the search engine market world-wide which gives it an enormous technological advantage. Together with Facebook, Alphabet dominates the digital ad market (Google-Facebook duopoly). Its cloud computing services is the fastest growing part of the company, which takes up a 7% of the global market share. According to some estimates, Google’s advertising revenues will exceed $230bn by 2023. Its global market share, however, will drop by 1% by then due to the growth of competing platforms, such as Amazon and Baidu.
Facebook owns social media platforms Facebook and Instagram as well as messaging services Facebook Messenger and WhatsApp. In the latest quarter, the total number of monthly active users across its platforms amounted to 2.7bn people. Its major source of revenue (97%) is advertisement on the social media platforms, but it is working on the diversification and further expansion of its revenue sources. For example, Facebook develops and sells virtual reality headset Oculus; it also receives revenue from business messaging on its messaging platforms; another revenue growth area is e-commerce on Facebook Marketplace and Instagram.
Amazon is an e-commerce giant as well as a leading cloud service provider. In the latest quarter, 69% of its revenue came from its online store and third-party seller services. Amazon’s retail e-commerce sales market share in the US is estimated to grow from 37.3% in 2019 to 38.7% in 2020 and 39.7% in 2021. Its cloud services AWS, which brought in 13% of the revenue (MRQ), takes up the largest global market share of 32%, and its revenue is expected to increase by 32% in 2020 compared to 2019. Amazon is also growing its digital ads business line and is expected to receive $40bn in annual ad revenue by 2023. That would mean an increase of more than 470% since 2018.
Microsoft has three business lines. Productivity and business processes segment accounted for 33% of revenue in the latest quarter and includes licensing and subscription services such as Microsoft Office 365 and Microsoft Dynamics suite as well as LinkedIn revenues. Microsoft Office 365 is in tight competition with Alphabet and its Google Apps. Microsoft’s cloud services, Azure, brought in 34% of the revenue and it corresponds to 19% of the global market share, the second largest. The third business line is personal computing (35% of the revenue), which includes Bing search engine advertisement, gaming and Windows OS licensing. Windows OS has 76% of the global OS market share worldwide, while the Xbox video game console takes up 35% of the global market share.
Microsoft is the only Big Tech company that did not face antitrust charges in 2020 and 2021.
FUNDAMENTAL QUANTITATIVE ANALYSIS
After a strong bull run in 2020, many tech stocks, including FAMAGs, are trading at premium to the market on a price-to-earnings basis and price-to-free-cash-flow. The sector’s free cash flow (FCF) has increased from $160bn in 2019 to $213bn in November 2020. The FCF yield has, however, decreased from 1.9% to 1.7% over the same period, remaining much lower than during previous highs in 2011, 2013, and 2016, but well above the dotcom bubble levels. A lower FCF yield means investors receive less attractive returns because a company has less cash to satisfy its debt and other obligations.
The table below shows some useful ratios and parameters for the three tech subsectors in the US. In terms of valuation, the hardware subsector is the least expensive, while the software industry has the highest price-to-sales (P/S), price-to-earnings (P/E) and price-to-FCF (P/FCF) ratios. The P/E ratio has increased sharply in the past months for the tech sector, but remains below the levels of the dotcom bubble, as shown in the figure below.
The software subsector also achieves the highest gross profit margin (GM) of 60%, followed by 40% for semiconductors and 35% for hardware, which is not surprising since manufacturing of actual physical products is more costly.
Regarding leverage, the tech sector in general is quite well-positioned. The debt-to-equity (D/E) ratio which measures total debt and financial liabilities against total shareholders’ equity reflects the proportion of equity and debt the company is using to finance its assets. The D/E ratio does not exceed 35% for the three subsectors.
Cash-to-debt (C/D) ratio that measures the financial strength of a company and is calculated by dividing company’s cash, cash equivalents, and marketable securities by its debt. If the C/D ratio is less than one, the company cannot cover its debt using the cash in hand. For the tech subsectors, the C/D ratio does not go below this threshold.
In terms of liquidity, the tech sector also shows good financial strength. The current ratio, that reflects a company’s ability to pay current, or short-term, liabilities with its current, or short-term, assets, is above one for the entire sector. This implies lower risk because a typical tech companycould liquidate its current assets more easily to cover short-term liabilities. The quick ratio, which is a similar but more conservative measure of liquidity, is also above one.
|Industry||P/E||P/S||P/FCF||GM [%]||D/E||C/D||Current Ratio||Quick Ratio|
COVID-19 and economic downturn
On one hand, COVID-19 has made a positive impact on the tech sector, speeding up digitalisation, and moving entertainment online. On the other hand, the tech industry is not immune to economic downturns: while customers, both enterprise and retail, grapple with spending cuts and future uncertainty, tech revenue growth will be negatively affected. In addition, the tech sector has suffered from supply chain disruption due to lockdowns. What makes the tech sector somewhat better positioned under current circumstances is the fact that certain IT investments can improve the efficiency and productivity of businesses, therefore, justifying some degree of IT spending. But generally, a continuation of the pandemic will imply a negative sentiment for the sector as a whole. However, that might not necessarily be reflected in the prices of tech stocks since the negative effect of a continued pandemic will be even more prominent for many other sectors as it has been in 2020. At the same time, there are no signs of the Federal Reserve increasing the interest rates, which also benefits the tech market.
The latest developments on the US stimulus relief package include the $1.9tn stimulus check suggested by President Biden. Markets’ initial reactions were negative as the new stimulus would imply higher corporate taxes, but in the long run, a substantial stimulus would lead to a more rapid economic recovery. The negotiations might, however, stretch out again as the proposition is already facing Republicans’ opposition.
US-China tech war
The tech war initiated by the US to reduce China’s tech advances has also hurt US and European sectors, with certain semiconductor companies, such as Micron and ASML, not being able to export products to their customers, Huawei and SMIC being an example. An escalation of the tech war could cost the market as much as $30bn in 2021. However, Joe Biden’s victory in the US election could mean a change in the course of the US-China tensions, which remains to be seen.
For this round of investment ideas, I would like to concentrate on more long-term trends and ETFs that include established companies in order to navigate in the bubble-like environment of the equity market and potential value rotation. All key information about the selected ETFs is shown in the table below.
Together with one of UCLIF’s analysts, Jasper Kennett, who has investigated the main trends within cybersecurity industry, we have selected this ETF because it offers an investment opportunity into long-term trends, while concentrating on industry leaders. The area of cyber safety has been of great importance for a long time, however, as the Covid-19 outbreak has prompted further digitalisation, the question of cybersecurity has become increasingly topical. Until 2027, the cybersecurity market, which was valued at $156.5bn in 2019, is predicted to have an annual growth of about 10%.
ISPY ETF aims to track the performance of the ISE Cyber Security UCITS Index. The index itself follows companies that actively provide cybersecurity technology and services. The industry can be separated into two directions: (1) Infrastructure Providers that develop hardware and software for protecting internal and external access to files, websites and networks; and (2) Service Providers that provide consulting and secure cyber-based services. Only companies of sufficient size and with high enough liquidity are included into the index. The recommended investment horizon for this ETF is five years.
The main market of the ISPY ETF is the US and Canada (81%), which is the most dominant region within the cybersecurity market.
As the US tech stocks have become increasingly expensive in their valuation, I would like to suggest investing into the European tech market which is rather cheap in comparison. The XS8R ETF provides diversified exposure to European equities as well as a mix of growth and value companies.
This ETF aims to reflect the performance of the STOXX Europe 600 Technology Index and consists of shares of leading technology companies in Western Europe that are involved in computer services, internet, software, computer hardware, electronic office equipment, semiconductors and telecommunications equipment. The index includes large-to-small capitalisation companies that are also the most liquid in developed Europe.
The top three countries that compose the ETF are Germany (38.42%), the Netherlands (25.76%) and France (11.94%).
|Potential upside (2021)|
|Major holdings (%)|
|Palo Alto Networks||2.7||Dassault Systemes||4.27|
|Blackberry||2.7||Amadeus IT Group||4.03|
|Qualys||2.3||JUST EAT takeaway.com||2.13|
 Here and henceforth IaaS market share in Q3’20.