Why the tech stocks bonanza may be ending and it’s time to hit the reset button on high hopes

Tai Hui says as tech companies will face challenges in the near future, investors should temper expectations and focus on firms with a broad range of businesses

PUBLISHED : Friday, 24 August, 2018, 10:17am
UPDATED : Friday, 24 August, 2018, 10:30pm

As the de facto IT technician in my household, I find that turning troublesome devices off and on again averts a crisis most of the time. Similarly, investors could benefit from hitting “reset” on their sky-high expectations for investment returns from tech sector stocks.

For years, US technology stocks have been the darlings of the global stock market, with good reason. The IT subindex of the S&P 500 has delivered a 19.6 per cent annualised return since the end of 2008, compared with 12.3 per cent for the main index. Going back further, over the past decades, technology has been an important part in investors’ portfolios. From Microsoft to Apple and Google, many companies that have transformed the way we work and live have also created tremendous value for investors.

The long-term outlook remains rosy, but there are a number of potential headwinds lurking in the near term. After all, this sector’s price-to-earnings ratio is currently at 18.9 times, 29 per cent higher than the 10-year average of 14.6 times, reflecting that investors are willing to pay a premium for these companies’ stocks in anticipation that high growth will continue in the foreseeable future. While the long-term direction looks sound, the path upwards is unlikely to be smooth.

Let’s start with some cyclical factors. In the latest round of earnings reports, tech companies reported earnings growth of 38 per cent in the second quarter of 2018 versus the same time last year, with 90 per cent of companies beating analysts’ forecasts. However, such impressive results are the outcome of very high profit margins, which are already showing signs of dipping. The possibility of higher costs, in the form of higher wages and regulatory costs, and slower revenue growth, could pose a challenge to maintaining high margins.

Tech companies have also been aggressively buying back their shares, often by raising debt. Out of some US$650 billion of share buy-backs by US companies so far this year, 42 per cent was by tech companies. This raises the question of why tech companies are using their cash to buy back their stock, which is already expensive, instead of investing in research and development.

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Questions over future revenue growth come from structural developments that could prompt investors to reassess these companies’ business models. For example, better protection of user data privacy is necessary, but this could potentially limit the revenue growth of social media platforms.

A number of tech giants have been fined, or are being investigated, for antitrust behaviour in Europe. Tech companies’ success partly relies on taking advantage of the networking effect of the masses, and the ability to tap big data and benefit from the economies of scale. Regulatory scrutiny over monopolistic practices would force companies to maximise such network benefits without stifling competition.

Then, there is growing competition. The smartphone market is increasingly fragmented, with Chinese producers capturing market share, both at the premium and budget level. Overall growth of the smartphone market is also starting to ease. Video streaming has benefited early entries, such as Netflix, but traditional entertainment companies, for example Disney, are entering the ring with blockbuster content.

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Resetting their expectations does not mean investors should avoid the tech sector altogether. Companies with a broad range of businesses are in a better position to diversify their risks. They can pull together more resources to meet these challenges, while still investing for the future.

Smaller companies and start-ups are supposed to deliver more explosive growth in the long run, but possible easing in the growth cycle in the medium term and rising funding costs are hurdles they will need to overcome. Insights into companies and their business models is needed to select the right stocks.

We don’t just throw away our computer or smartphone each time they stop working. Sometimes they just need to be turned off and given a minute, before we fire them back up again, for them to serve their purpose.

Tai Hui is chief market strategist at JP Morgan Asset Management