Sector report by Maria Lomaeva, 27 November 2020
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 the 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.
As two potential investments, I suggest SSGA SPDR’ SXLK ETF that tracks the S&P Technology Select Sector Index, and WisdomTree’s INTL ETF that follows the Nasdaq CTA Artificial Intelligence Index.
FUNDAMENTAL QUALITATIVE SECTOR ANALYSIS
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
The semiconductor industry became a central part of the US-China tech war. 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. In addition, the Trump administration tried to ban ByteDance’s social media platform TikTok and Tencent’s messaging app WeChat.
During the pandemic, Big Tech companies Facebook, Amazon, Microsoft, Apple and Alphabet (FAMAGs) have further consolidated their dominance and driven the market upward despite antitrust charges against Facebook, Amazon, Apple and Alphabet from the US Congress.
Recent price action
The tech sector had a strong bull run in 2019, and after the March 2020 sell-off, it quickly recovered. As of November 27 2020, the S&P IT index is 33.01% up YTD, while NASDAQ Composite is 34.25% up YTD.
FUNDAMENTAL QUANTITATIVE 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|
Source: Gartner (October 2020)
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 the 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 the 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).
Competition and regulation
Competition is a topical matter within the tech industry as four Big Tech companies were accused of abusing their market power by the US Congress earlier this year. To combat the monopoly, the Congress suggested to restructure and break up big businesses, among others.
Despite the antitrust investigation, the Big Tech companies continued to consolidate during the pandemic and through M&A activity in 2020, 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
Although a successful coronavirus vaccine would undoubtedly mean the beginning of a global economic recovery, it could drive the price of major tech stocks down. As investors have been hedging their risks with Big Tech during the pandemic, once the virus is under control, investment opportunities will lie in more cyclical stocks. There already has been a tech sell-off after Pfizer’s announcement about their effective vaccine. However, the rate at which investors will move their money from tech to other sectors will most probably be gradual.
Next tech bubble
After a strong rally within the tech sector during the pandemic, which has pushed up valuation indicators and especially those of Big Tech, concerns about a new tech bubble emerged with comparisons of the dot-com crash in 2000. There are, however, some significant differences between the two situations. Firstly, the Big Tech companies today have a more solid cash flow generation and balance sheets with strong earnings. The average P/E of FAMAGs is still a fraction of the average P/E of tech companies in 2000. Secondly, the dot-com bubble was exacerbated by the influx of liquidity from the Federal Reserve followed by its sharp removal that burst the bubble. The Fed did indeed insert a huge amount of liquidity in the beginning of the pandemic, but the money is not excessively allocated to stocks in the US and world-wide, and it has not been removed from the markets. Therefore, it is too early to expect a major correction.
As mentioned above, Big Tech has become subject to monopoly accusations. However, the prospects of aggressive regulations and any change of the antitrust laws have faded after the US election, when the Democrats, who are the most interested in implementing these policies, did not manage to gain control over the Senate. Big Tech could benefit from a paralysed legislature and lack of action from policymakers.
In addition, a monopoly would commonly lead to expensive services or products of poor quality. The Big Tech companies, on the contrary, invest large amounts of money into R&D to keep their customers interested. This could help Big Tech to maintain its dominance even if the antitrust laws change.
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. For context, FAMAGs’ shares have grown about 49% year-to-date on average, while the S&P 500 is up only about 11% for the year.
Apple was the first ever company to have reached a $2tn market cap in August 2020. In the latest quarter, Apple received half of its revenue from iPhone sales, despite COVID-19 related delays in production of the latest model. Apart from hardware, Apple also offers subscription services and digital advertisement, which brought in 20% of revenue (MRQ). 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 (80% of total revenue in MRQ) as well as cloud computing services (7% 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 (99%) 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 (including 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 35% of the revenue and it corresponds to 19% of the global market share, the second largest. The third business line is personal computing (32% 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.
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 free cash flow (CFC) yield has also decreased through 1H20, from 2.8% in 2019 to 2.3%, remaining much lower than during previous highs in 2011, 2013, and 2015. A lower CFC yield means investors receive less attractive returns because a company has less cash to satisfy its debt and other obligations.
However, looking at the P/E-to-growth, or the PEG ratio, tech stocks are actually trading at a discount compared to 2019, with estimates predicting further ratio decline in 2021-2022. A lower PEG ratio means that the stock may be undervalued given its future earnings expectations.
Additionally, the gross profit margin for the sector remains high and over 50%, although it has decreased from almost 60% in late 2019. The current ratio oppositely increased since last year and became above one, meaning that the sector’s current assets remain higher than its current liabilities.
|Current ratio (MRQ)||$1.16|
|Price to Free Cash Flow (TTM)||$31.02|
|Gross profit margin (MRQ)||50.57%|
|Price/Earnings-to-Growth (2020; estimated)||21|
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 negotiations regarding a second US stimulus check have been ongoing for months. If the US government finally comes to an agreement, that will boost the markets and the tech sector.
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 is yet unknown.
SXLK ETF tracks the performance of large sized US IT and telecommunication services in the S&P 500 Index by tracking the S&P Technology Select Sector Index as closely as possible.
Its three largest holdings are Apple (22.71%), Microsoft (19.15%) and NVIDIA (4.31%). Almost 80% of the stocks it holds are of the companies in Technology Hardware & Equipment (44.09%) and Software & Computer Services (35.27%). The SXLK ETF’s base currency is USD and it is traded in USD with an expense ratio of 0.15%.
The SXLK ETF offers an opportunity to invest in the US tech market leaders and passively follows the index which in recent years has been a lucrative investment strategy with low fees. In the past year, its development closely resembled the growth of the NASDAQ 100 index. Presumably, 2021 will not be as prolific for the tech sector as 2020 with more progress being made on the vaccine development. Given the continued digital transformation as well as potential risks of a growth-to-value rotation, I believe a potential upside for SXLK ETF in 2021 could be 30-35%.
The INTL ETF seeks to track the price and yield performance of the Nasdaq CTA Artificial Intelligence Index. The Index itself tracks the performance of companies engaged in AI and utilises CTA’s AI Intensity Rating, which measures the perceived degree of a company’s AI sector involvement.
The three largest holding of the ETF are Corelogic (real estate property data and analytics firm; 3.64%), Xilinx (develops highly flexible and adaptive processing platforms; 3.58%) and Nuance Communications (conversational AI developer; 3.35%). Over 83% of the fund’s share is invested in Software & Computer Services (43.75%) and Technology Hardware & Equipment (39.74%). The largest holdings by country are in the US (60.37%) and Taiwan (13.32%). Its base currency is USD but it is traded in GBX which makes it a subject to forex risks.
This is a passively managed fund that has had a very similar development to NASDAQ 100, and often outperformed it in the past year. Given the prospects of the future AI development, I believe the INTL ETF can grow by 35-40% in 2021.
|ETF||Price||Fee||Potential upside (2021)|
 Here and henceforth IaaS market share in Q3’20.
 Here the tech-heavy Nasdaq Composite index serves as a proxy for the tech market.