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It’s a trillion-dollar question: When will the technology sector rebound and lead market growth again?
Many of the world’s largest companies – Apple Inc. APPL-Q, Microsoft Corp. MSFT-Q, Alphabet Inc. GOOGL-Q and Amazon Inc. AMZN-Q – that consist of trillions of dollars of market capitalization were down close to or more than 30 per cent in 2022.
Indeed, an opportunity is likely at hand for an overweight focus on technology – only with a hitch, say those who track the sector.
“It’s important to differentiate between growth tech and profitable tech,” says Damian Fernandes, managing director at TD Asset Management Inc. in Toronto.
The aforementioned “big tech” companies fall into the latter group and should be part of a diversified portfolio given their blue-chip qualities and relatively clear paths for ongoing cash flows.
Equally important, “a lot of those cash flows are from established customers and … being returned in the form of dividends and stock repurchases,” he says.
Mr. Fernandes points to Apple, which, as of mid-December, had bought back US$89-billion in stock while paying out US$15-billion in dividends.
“I could go through the same example with Microsoft, Accenture, or any large-cap, profitable tech company,” he says.
In contrast, the other, former group consists of speculative, growth tech companies that saw strong demand during the pandemic. These include high-profile names like Zoom Video Communications Inc. ZM-Q and Peloton Interactive Inc. PTON-Q.
“They are still great companies … but figuring out what their cash flows will be like 10 to 15 years out is challenging,” says Étienne Joncas Bouchard, exchange-traded fund (ETF) strategist with Fidelity Investments, who tracks the sector.
In turn, while Fidelity’s “High Quality” line of ETFs, including Fidelity U.S. High Quality Index ETF FCUQ-T, are overweight technology by about 7 to 8 per cent, the portfolios generally don’t hold these more speculative companies, he says.
“The way we have been approaching that is to favour technology stocks by their fundamental characteristics,” he notes, including strong free cash flow margins, high returns on invested capital and stable earnings.
Even though quality tech companies like Apple and Microsoft have seen their share prices fall significantly, Mr. Fernandes says they still generate free cash flow and return it to investors.
As a result, analysts don’t expect either one to have positive cash flows until 2025, he says.
“First, you have to believe analysts can forecast with absolute prescience, which is debatable,” Mr. Fernandes adds. “Second, you must be confident that once they’re generating cash, they will … return it to shareholders.”
Risks aside, many investors remain broadly interested in tech, says Lara Crigger, editor-in-chief of VettaFi LLC, which provides market data for advisors, in New Orleans.
“The Qs are still one of the most highly traded investments in the world,” she says, referring to Invesco’s Nasdaq ETF series that includes Invesco QQQ Trust QQQ-Q.
“Investors, for example, added US$4-billion into QQQ Trust in November, the most of any ETF in the U.S.”
Driving interest is the belief the Nasdaq Composite Index is poised to rebound, led by its roughly 50 per cent weight in technology, she says.
“People have been looking for the right time to get back in,” she adds.
Ms. Crigger points to potential drivers of growth piquing investors’ interest.
“We haven’t really come to grips in the U.S. that we’ve lost more than a million people and millions more are temporarily and permanently disabled,” she says of the pandemic’s legacy.
In turn, technology could be critical for companies facing labour shortages.
“So, this might be the year, for example, that the disruptive technology ETFs see a turnaround.”
She adds these funds hold many companies that, while speculative, offer services reducing labour inputs that could draw renewed interest from investors.
However, Mr. Fernandes cautions disruptive tech companies could still face challenges amid higher interest rates, given they rely more on leverage and future earnings would continue to be less attractive to investors than the risk-free rate of about 4 per cent.
Even big tech like Meta Platforms Inc. META-Q – down more than 64 per cent in 2022 – faces uncertainty.
Although a leader of the previous bull market, Meta’s future cash flows are less clear today.
Mr. Fernandes says Meta is investing heavily in virtual reality (VR) and the metaverse, which have uncertain paths to future profitability.
“With nascent technologies like VR, you don’t know who the winners will be,” he says.
At the same time, Meta’s cash-generating businesses Instagram and Facebook are losing market share to TikTok, Mr. Fernandes says.
To some, the sector today bears similarities to the dot-com bubble’s aftermath, when companies like Microsoft were beaten up, much like today’s growth stocks.
Indeed, Microsoft continued to grow in the aftermath, Mr. Fernandes notes.
The problem was it had started with such a price-to-earnings valuation during the bubble that “it took 10 years for its valuation to recover and grow again,” he says.
An upside for advisors today is they have more choices – ETFs, notably – for diversified exposure to mitigate risk for clients, Mr. Bouchard says.
“So, rather than figuring out if this stock is better than the other, you buy the basket and get diversification with potential upside,” he says.
Furthermore, Mr. Bouchard argues exposure to technology, despite its risks, is still warranted for suitable clients.
“We’re going to be using tech for the rest of our lives, so the sector’s importance is not going away,” he adds.
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