• We believe that the technology sector has already experienced an earnings recession, and is now in the recovery phase, marked by higher sales and earnings growth, as well as increasing profitability.
• Even in a high interest rate environment, Big Tech companies are resilient due to their stronger balance sheets and treasure trove of cash. They also benefit from the sustained demand for cloud computing in the digital age.
• Big Tech companies stand out due to their formidable competitive advantages and wide moats, enabling them to further strengthen their brand influence while fending off competitors.
• Concerns that AI will kill Big Tech are exaggerated, with these firms instead being best positioned to capitalise on this next phase of growth with the tremendous capital and talents at their disposal.
• Despite concerns about Big Tech stocks being overvalued, we believe the potential upside from AI, along with other megatrends like cloud computing has not been fully reflected in current prices. Therefore, we have upgraded the star rating for the Digital Economy from 2.5 Stars "Neutral" to 4.0 Stars "Very Attractive," indicating an upside potential of 32.0% by the end of 2025.
US equities have had an exceptional year, with the S&P 500 generating a return of 20.71% (in SGD terms). They outperformed the 14.72% delivered by the Nikkei 225, 13.21% for the STOXX 600 and 2.98% for the MSCI AC Asia ex Japan Index as of 22 November 2023 (Figure 1).
Figure 1: US equity market has outperformed other major markets year to date
Diving deeper, the Big Tech stocks have generated the bulk of the returns within the S&P 500, accounting for about 60% of the rally as of 22 November 2023 (Figure 2).
Figure 2: Majority of the returns in the S&P 500 was driven by the Big Tech stocks
After a strong performance by Big Tech this year, investors are beginning to wonder if they can continue to outperform. Investors have also questioned whether these companies would be replaced in the years to come. We believe the short answer is no, and we expect another decade of outperformance by Big Tech stocks, driven by artificial intelligence (AI) and strong competitive advantages.
Earnings recession is over for the technology sector
For the past year or so, the possibility of a US recession has constantly been on investors’ minds. But in the past few months, the market narrative has shifted from a hard landing to a soft landing. In our view, we believe that we are already experiencing a recession, just not an outright total recession. Instead, we are in a rolling recession, where different sectors go through a downturn in a staggered manner.
In particular, we believe that the technology sector has already undergone a recession, marked by the surge in layoffs (Figure 3) and an earnings slump last year. As technology companies started to focus on capital efficiency, they announced massive job cuts and cost-cutting initiatives. This has begun to bear fruit as earnings growth of the technology sector has started to pick up after bottoming in 1Q23, despite the challenging macro backdrop (Figure 4). Meanwhile, profit margins have also largely troughed between 4Q22 and 1Q23 as a result of the focus on capital efficiency.
Related article: Picking the winners within the technology sector as challenges lie ahead
Figure 3: Layoffs in the technology sector have already peaked and have begun to moderate
Figure 4: Earnings growth for Big Tech has bottomed and is recovering
Despite the upward revisions of consensus revenue and earnings growth in the recent months, we believe these Big Tech stocks will continue to outperform as investors are still underestimating the faster-than-anticipated adoption of AI, which will drive sales growth higher and result in profit margin expansion, much like Nvidia Corp (NASDAQ: NVDA).
Higher-for-longer interest rates unlikely to derail growth
In the fight against inflation, the Fed expects to keep interest rates higher-for-longer, which tend to pressure technology stocks as higher long-dated bond yields make companies’ future cash flows less valuable when discounted to the present. This also raises the cost of debt, preventing companies from borrowing as freely as before.
However, we believe the higher-for-longer interest rate environment is unlikely to derail the growth of Big Tech companies due to their prudent management of debt while maintaining a war chest of cash. Big Tech companies have amassed a ton of cash reserves over the years, so much so that most are able to pay off their debt instantly if they wished to do so (Figure 5).
Figure 5: Big Tech companies have amassed a ton of cash reserves
Furthermore, they are cash generating machines, raking in billions of free cash flow per quarter, highlighting their capability to operate with limited reliance on external borrowings (Figure 6). Lastly, these Big Tech companies can also benefit from the high yields by investing their cash reserves into shorter term debt instruments to collect interest, building up their cash pile even further.
Figure 6: Big Tech companies generate billions of free cash flow per quarter
As such, despite the challenging conditions of high interest rates and a slowing macroeconomic environment, Big Tech companies will continue to thrive and expand. In the current digital age, the demand for cloud computing remains on its path of secular growth. Cloud services offer numerous advantages over traditional on-premises infrastructure, including superior scalability, resilience, and cost management.
According to Synergy Research Group, enterprise spending on cloud infrastructure services grew 18% year-on-year (YoY), despite the current economic and political climate, as there is clear evidence that generative AI technology and services are driving demand higher. Meanwhile, the worldwide market share for the Big Three cloud service providers increased from 65% to 66%, indicating that their sheer dominance remains intact (Figure 7).
Figure 7: Big Three cloud service providers continue to increase their market share
Big Tech’s strong competitive advantages enable them to expand their brand influence and fend off competitors
As previously mentioned, what sets Big Tech companies apart from their peers are their strong competitive advantages, which include having wide moats to fend off competitors, while having a sustainable and global business model.
Related article: Why these technology stocks are better than the rest
With their robust presence in the market and well-established positions, Big Tech companies have the ability to bolster their brand influence and potentially increase their lobbying power. Despite ongoing discussions about breaking up these companies in recent years, there has been little change so far. The fines imposed on them are considered inconsequential due to their substantial cash reserves. Additionally, being headquartered in the United States provides them with a strategic advantage and more freedom, compared to large technology firms established in other countries, such as China, where a single decision by the ruling party can quickly reshape the entire technology sector.
Today, some of the most durable moats are built on advantages like network effects and data within a product or service ecosystem, which is precisely what these Big Tech companies are known for. By having wide network effects and distribution channels, as well as a lack of real competition, these Big Tech companies are set to thrive and remain dominant in the years to come.
AI will not kill Big Tech, but rather propel them to greater heights
AI has been the hot topic in recent months, ever since the launch of ChatGPT in late 2022. Since then, there have been several companies and start-ups trying to ride on this wave with numerous large language models (LLMs) being launched. On the back of this technological development, investors may be increasingly worried that AI will kill Big Tech as it seeks to disrupt their business models, and usher in a new age of technology leaders.
However, we believe that this is not true. Instead of killing Big Tech, we believe that AI will propel them to greater heights, increasing their market share in their respective domains as well as revenue and profits. AI is also technically not new, as for the past decade even before the launch of ChatGPT, AI has been deployed in numerous commercial use cases across industries, be it content recommendation, navigation or virtual assistants etc. In fact, Big Tech companies have long been harnessing the power of AI across various domains.
• For Google, Google Search uses AI algorithms to improve search results and personalize user experience while Google Photos employs AI for image recognition, categorisation, and facial recognition.
• For Meta, content moderation utilises AI to identify and moderate content, including hate speech and inappropriate material while news feed algorithm uses AI to personalise users' news feeds based on their preferences and behaviors.
• For Amazon, recommendations systems employ AI algorithms to suggest products to customers based on their browsing and purchasing history while Alexa, Amazon’s virtual assistant, utilises natural language processing (NLP) and machine learning to understand and respond to user queries.
• For Microsoft, Azure Cognitive Services offer a suite of AI services for computer vision, speech recognition, and natural language processing. Microsoft AI Research: Invests in AI research and development across various applications. Microsoft’s recent investment in ChatGPT nets them a 49% stake in the upstart firm, further elevating their standing in the world of AI.
• For Apple, Siri, Apple's virtual assistant, integrates AI for voice recognition, language processing, and contextual understanding while its Face ID uses facial recognition technology powered by AI for secure device authentication.
Today, generative AI takes it a step forward, as it is essentially a prediction model that works by learning relationships between existing data points and creating new data from it. This function can be extremely powerful, with the potential to boost productivity, and is still rapidly finding new applications. Down the road, we anticipate that the broader adoption and utilisation of generative AI will expand, bringing benefits to Big Tech companies in particular, as they have deep pockets and the talent to develop and further enhance them.
Attractive valuations, potential is not fully priced in
While some investors may think that it is too late to invest in Big Tech stocks given the recent rally, we believe the upside from megatrends such as cloud computing and AI has not been fully priced in. We continue to expect strong earnings growth from these Big Tech companies moving forward.
On top of structural and secular reasons, with the earnings recession in the technology sector behind us, we expect strong earnings growth from this sector moving forward, particularly the Big Tech companies that will lead the next phase of growth, backed by their strong competitive advantages and sheer market dominance.
With these reasons in mind, we have decided to upgrade the star rating of the Digital Economy from 2.5 Stars “Neutral” to 4.0 Stars “Very Attractive. Based on our fair PE multiple of 30X, we arrive at a target price of USD 45 for the Invesco NASDAQ Internet ETF (NASDAQ: PNQI), representing an upside potential of 32.0% (Table 1) by the end of 2025. Apart from ETFs, investors who are keen to invest in technology sector via an active approach can also consider the Fidelity Global Technology A-ACC-USD Fund.
Table 1: Projections for NETX Index
|
Nasdaq CTA Internet Index |
2022 |
2023E |
2024E |
2025E |
|
PE Ratio (X) |
49.7 |
35.5 |
27.5 |
22.7 |
|
Projected Earnings Growth (YoY %) |
-20.8% |
39.8% |
29.1% |
21.2% |
|
Projected Earnings Per Share (EPS) |
21.2 |
29.6 |
38.2 |
46.3 |
|
Target Fair Price for ETF in USD (Based on a fair PE ratio of 30X) |
- |
- |
- |
$45 |
|
Potential Upside (%) |
- |
- |
- |
32.0% |
|
Source: Bloomberg Finance L.P., iFAST Estimates |
||||
Figure 8: NETX Index Price vs EPS
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