While the sector offers the chance of owning a growth play in a low-rate environment, recent share price stalls are making investors more cautious about where they put their money.
The technology sector has been a happy hunting ground in the COVID-19 pandemic where longer-term shareholders were joined by cashed-up retail investors. But a bout of weakness for share prices has forced a tech investing rethink.
The NY FANG+ index is up 124 per cent and the ASX technology index has risen 116 per cent from mid-March to the end of August. But the rally ground to a halt in late August and the NY FANG+ index is down 11.4 per cent from its peak while the ASX tech index is down 8.3 per cent.
In the US, Amazon and Apple are well off peak levels. In Australia, the buy now, pay later glamour stocks have sold off sharply, with Afterpay down 20 per cent, Sezzle down 43 per cent and Zip down 39 per cent.
Tech stocks rallied hard from March as investors hunted for companies that could deliver earnings growth, central banks threw money at the global economy and people at home turned to the sharemarket.
"There’s been a really material re-rate for the sector," says fund manager Jonathan Koh at Greencape Capital.
A number of share price drivers are playing out for technology companies, he adds. The shift to online and digital in the pandemic has compressed perhaps two, three or four years of growth into months.
Central banks and governments have thrown massive amounts of stimulus at economies to prop them up during the pandemic, culminating in the Federal Reserve saying earlier this year it would buy corporate bonds.
"They have obviously tried to influence the cost of debt," he says, with this boosting valuations for risk assets such as shares.
"A third factor has probably played out as well and that’s the psychology of markets – where things build on each other and there’s a fear of missing out particularly perhaps in the retail market."
The rise of the retail investor as people stuck at home flocked to stocks has led to a phenomenon known as Robinhood investing – after the US app favoured by retail investors.
Record numbers of brokerage account openings and newer technologies have made it easier for people to open online trading accounts while fiscal support and superannuation withdrawals have also been put to work, says William Curtayne, portfolio manager at Milford Asset Management.
"Retail investors make an assumption about whether companies will do well and buy in," he adds. "In Australia, the tip of the spear is the buy now, pay later names. In the US, it's Tesla and others."
Buy now, pay later share prices have soared to giddy heights since March. Afterpay's share price jumped by 939 per cent from mid-March to late August, while Sezzle rallied almost 3000 per cent in that timeframe and Zip surged 721 per cent.
The gains are in part a reversal of heavy losses made at the start of the pandemic when investors panicked about the sector's close links to retailers. Fears faded as some retailers saw extraordinary demand during lockdown.
The sector has its drawcards – it's expanding rapidly and offers a rare chance at owning a growth play.
But for a company like Afterpay, says Koh, its share price has risen to such heights that it has little wriggle room – in other words, it's priced for perfection. "You have to use really bullish assumptions to backsolve to the current valuation. And we are talking about assumptions that are 10 years out."
Competition and regulation threats also hang over the buy now, pay later sector, adds Koh, noting that the space is particularly crowded. "There’s a reasonably long list today of operators in that area. You’ve got Commonwealth Bank partnering up with Klarna.
"There are some really good business models out there but you have to distinguish between companies that have a good business model and companies that have a good business model and are overvalued."
Mike Aked, director of research at Research Affiliates, says the problem starts when investors start "losing the idea about what you are paying for". "That's the step to overvaluation – when no one is talking about how much you are paying for earnings," he adds.
Retail investors are skittish. "If they stop seeing the profits and the doubling of returns, they will pull out and that creates a snowball effect."
For some, tech investing isn't about jumping into the hottest stocks of the day. Investors have been drawn to the sector for some time for its structural growth prospects."These stocks are growing fast, profits are strong, they have a reason to exist," says Aked.
Some technology companies have experienced a fundamental step change that is likely to be sustainable, adds Koh. "Growth in Amazon's AWS and some of the other cloud providers – that's not reversing. If anything, that’s going to keep rolling through."
Koh is not shying away from the technology sector. "We are selectively stock-picking names that we think have a better ability to grow though the cycle," he says. He likes companies such as Appen, Nvidia, REA and SEEK.
"Names with attractive relative valuations and strong bottom-up fundamental stories still have that tailwind of secular growth. We are also really focused on quality management teams. That’s really critical."
The pandemic has seen tech investing move beyond a small group of technology stocks – Wisetech, Appen, Altium and Xero – to a much wider cohort of companies, says Stephen Wood, co-founder of Eiger Capital.
"In January, we would have been WAAAX-centric and talking about online-centric businesses in terms of 'will Redbubble survive, will Marley Spoon make a go of it'. The winners of 2020 are the companies that have already been embracing the structural change that technology is bringing to their business and have been able to accelerate it," adds the fund manager. Wood holds Redbubble, Life 360 and NextDC in his portfolio.
A permanent benefit from a shift to online will come partly through an expansion of marketplaces, he says. An online and store-based retailer can now more easily reach a global marketplace and is also likely to find it easier to remove capital from its business.
"We are really talking about leases and stores. They are still going to need some but they might need less," he says. "Such a move would take their costs down and return on capital up.
"The biggest thing to focus on next year is going to be withdrawal of stimulus. The companies that have done well out of tech will continue to be the ones that are well-placed."
Milford has taken profits on some tech names but retains core holdings such as Xero, Megaport, REA and Goodman Group.
Curtayne says the last two are "bigger, stronger companies that have benefited from these trends but are not as high octane". "They are stable businesses with a lot of earnings. If there is an unwind in some of these viewed beneficiaries, they probably won't unwind as much as other companies."
Technology stocks have benefited from central banks pumping money into the global economy and lowering interest rates and bond yields as they try to support ailing economies.
"The valuation of these companies is very tied to the discount rate," says Curtayne. A rise in the discount rate "can take the wind out of these growth stocks" as happened in the last quarter of 2018.
There's a big difference between profit growth and share price growth for some of these companies. "Share prices aren't as bullet-proof as people think," adds Curtayne.
Still, the Federal Reserve is strongly committed to making sure that interest rates and bond yields stay low and it will be hard for interest rates to go too much higher unless there's a shock, the fund manager adds. A COVID-19 vaccine could be the kind of event that causes a big jump in bond yields. The US election is another wildcard.
Over the longer term changing expectations of inflation could hit the tech sector. If stimulatory fiscal policy, very loose monetary conditions and perhaps some deglobalisation does manage to generate inflation, says Curtayne, "then you would find a big reversal of the sectors that do perform well"."In an inflationary environment, you would want commodities and real asset companies. Growth companies do poorly," he adds.
But without significant inflation, "then it's hard to argue why you wouldn’t continue with a portfolio more structured to growth and tech".