March this year marked 25 years since the dotcom crash, and it seems investors are once again expressing concerns over the prospects for the technology sector.
In the immediate aftermath of the bursting of the TMT bubble in 2000, investors ran for the hills. The IA Technology sector was about as popular as UK equities are today, and it consistently sat at the bottom of the sales charts as investors were fearful of getting burnt again.
Yet that all changed in the past decade with the emergence and subsequent dominance of what we know today as the ‘magnificent seven’. Such has been the run of the tech giants that they now represent close to 30% of the S&P 500. But nothing lasts forever in investment.
Since the start of the year (to 4 April) there has been a notable shift in performance, with the S&P 500 down 16.5% for the year to date and the Nasdaq falling by 18.3%. The CNBC Mag 7 index is down 23.97%.
With concerns already raised about the level of concentration in the market, both in the technology sector and in the US markets more generally, investors have now even started to talk about a ‘dotcom bust 2.0’. So, is it time to go underweight in tech?
In this month’s head to head, Liontrust’s James Klempster (pictured left) explains why he is reducing exposure to mega-cap tech, while Mike Seidenberg (pictured right), of Allianz Global Investors, reminds us the trajectory for tech is never linear.
James Klempster, head of equities, deputy head of multi asset, Liontrust
There can be little doubt as to AI’s potential to transform the way we live, work and socialise. Such has been the widespread positivity on AI, the overarching belief in the technology’s potential is very much ‘the sky is the limit’.
In the past couple of years ‘the sky is the limit’ seems to also be the mantra that has been applied to technology stocks and most notably those at the forefront of research and development in AI-related fields.
Inevitably, with any new technology it is difficult to define its likely long-term impact and who will be the ultimate beneficiary of the technology. History is replete with examples of new technology zeitgeists ripe with promise of a new era for society, that drive valuations way above what can be considered normal.
Elevated valuations have historically, over the long run, reverted to the mean either via profitability catching up with the blue sky in share prices or via gravity bringing share prices down to match earnings levels.
Which one of these two scenarios is likely for the AI mega caps? Clearly none of us can say with certainty. What we can say is there has been an extraordinary capex cycle with huge sums being spent on equipment, such as chips and R&D, for the building of the models AI runs on.
On one hand, some AI-related stocks, for example the ones that are selling to this flood of money, have had huge revenue and profitability that would be unlikely to continue in perpetuity. On the other hand, there is a large number of AI-related stocks that are making these vast investments and so, arguably, their profitability is being hampered by their desire to generate a first-mover advantage.
Swings and roundabouts
The challenge for investors today is that, unlike profitability, which is ultimately the result of a company’s fundamental performance (and accounting practices), valuations are a result of what people, collectively, are willing to pay for a future income stream in the form of capital gains and dividends, which stem from the company’s fundamental performance.
Willingness to pay boils down to sentiment and the one reality we can probably all agree on is that sentiment is fickle, unpredictable and fast acting. Whether it be runs on banks during the financial crisis or the collapse of tulip mania in 1637, sentiment can change quickly and go from being irrationally optimistic to irrationally pessimistic in short order. Markets tend to overdo it on both sides, which can lead to big swings in prices.
To put it bluntly, a brilliant business at the wrong price is going to be a bad investment. So, even if the AI revolution turns out even more transformational as even its keenest cheerleaders may point out, it is not a given that the companies which have the competitive edge today can crystallise that competitiveness in perpetuity.
Diversification is extremely important in multi-asset portfolios. Investment portfolios need to be built in a way so that they have a suite of different returns drivers and are not overly sensitive to any one risk factor. Aside from the potential for underwhelming returns, we see higher valuations as a source of significant potential risk.
In our investment portfolios, we have a neutral stance to the US market overall on the basis that there are decent valuations for the majority of stocks in the US, but this picture is muddied by the valuation of mega-cap technology names.
As a result, we use a blend of active managers that use value, growth, quality and smaller company investment styles to reduce our exposure to mega-cap tech. Furthermore, in our Dynamic Passive range, we have added an equally weighted S&P 500 tracker fund to dial down exposure to mega-cap technology.
More generally, while we are cautiously optimistic on the path of equity markets from here, with an overweight score of 4 out of 5 for the US, Japan, Asia ex Japan and EM, we have a neutral allocation to fixed income in order to provide portfolio ballast should sentiment turn in the short term.
Mike Seidenberg, lead portfolio manager, Allianz Technology Trust
Technology has been on an incredible recent run, with the magnificent seven and AI excitement driving continued outperformance. But so far this year, heightened geopolitical uncertainty and concerns over the economics of AI hyperscalers have slowed momentum, leaving some investors to seek safer assets.
However, it is important to remember although technology has delivered exceptional returns for well over a decade, this trajectory is never linear. As long-term investors, we constantly remind ourselves that short-term shocks are inevitable, and unless something happens we consider a thesis-changing event, we remain confident in holding a portfolio of innovative tech businesses at the forefront of the secular shifts that are reshaping how we live and work.
The tech sector, and indeed the US market, has recently been inseparable from the fortunes of the magnificent seven. Their combination of massive valuations and exceptional growth has made them impossible to ignore. But although their momentum is primarily attributed to AI excitement, it’s important to remember these are all very different businesses, with very different growth rates and return profiles.
As a result, we have been selective in our allocation to these businesses and have only held a long-term overweight position in Meta. As active portfolio managers, our priority is managing risk and reward.
With valuations at current levels, we are comfortable maintaining an underweight allocation to the magnificent seven and are proud to have closely matched our benchmark index despite their outperformance, demonstrating there is much more to the tech sector than just these businesses.
Picking the winners
There is no doubt of the transformative power of AI, and it remains a headline theme in our portfolio. However, picking the winners in the AI race remains challenging, so we are focusing on companies that are already leaders irrespective of AI, but who are positioning themselves to benefit from adoption, further augmenting already great businesses.
Cybersecurity exemplifies this and has been a key sector in our portfolio for several years, benefiting from secular demand in response to rising digitalisation. A new range of threats have emerged, including the rise of AI-powered attacks. This has boosted demand for cybersecurity and spurred innovation, as providers meet fire with fire, deploying AI to detect anomalies and automate responses.
Similarly, cloud computing is another longstanding theme in the portfolio. Rising demand for computing power, and the benefits to businesses of ‘right sizing’ technology infrastructure without the need for costly investment has been a proven thesis over the past decade, and demand for computing power to train AI models has only catalysed this.
Lastly, enterprise software remains an exciting sector. Following the wave of digitalisation imposed by the pandemic, many companies since cut back on investment in the following years. We project enterprise software providers to benefit from pent-up demand in 2025, with leading providers integrating AI into existing offerings to improve the range of services they can provide.
Technology remains a key enabler across almost every industry and will continue to produce companies that can solve difficult problems and deliver long-term share price growth. In the short term, we remain confident in the prospects for technology which continues to benefit from digitalisation, AI and a more favourable regulatory environment, while remaining conscious of the need for diligent risk management as we navigate geopolitical uncertainty.
And with sectors such as quantum computing, automation and robotics, and space exploration continuing to make strides, there are countless reasons for excitement.
This article appeared in our sister publication, PA adviser.
