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This has been a difficult year for the world economy, and the outlook for 2023 does not give significant cause for optimism. Recession is likely across most major economies as the world adjusts to higher interest rates and inflation. In this gloomy environment, can technology investments still thrive?
Technology is often pigeon-holed as a pure growth investment that only does well at times when economic activity is high. 2022 seemed to confirm this view, with the sector lagging its peers as uncertainty mounted. Share prices fell even as operational performance for many technology companies remained relatively robust.
There are historic reasons for this perception of technology. It is a legacy of a time when technology operated on a cycle. Companies would only invest in new capacity and systems when they had money to spare, meaning technology spending was feast or famine depending on the economic climate.
Today, technology is multi-layered and constantly evolving, with both defensive and growth elements. There are clear reasons why it has changed. Technology is no longer a choice for most businesses. They cannot only invest in technology when the time is right, but instead need ongoing technology investment to retain their competitiveness. Technology is now part and parcel of doing business.
Equally, cloud computing has moved the dial for many businesses. Instead of vast investment in technology infrastructure periodically, technology is ‘on demand’ through the cloud. 94% of all companies use cloud computing in their operations with the cloud computing market worth $269bn in 2021. The pandemic has hastened cloud adoption. While many companies still use on-premise servers, the direction of travel is clear and has reduced the cyclicality of technology investments.
The technology universe is vast and there are many companies that fit the definition of ‘defensive’. These are companies that grow their earnings in good and bad economic conditions, that may pay consistent dividends or reinvest in research and development to support their long-term growth. Their products are likely to be necessary rather than discretionary, which gives them pricing power in tough environments.
It is worth noting that this defensiveness may not be immediately reflected in share price performance. 2022 has been a year in which operational performance has often diverged from share price performance. Microsoft, for example, continued to outpace earnings expectations as adoption of its cloud services rose, but saw significant compression in its valuation, leaving its share price almost 30% lower over the year.
In our view, companies tend to be defensive for three main reasons: pricing power, structural growth and the productivity gains they deliver to companies. While this may not be appreciated by investors in a single year, these characteristics tend to be realised over the longer-term.
Apple shows the power of a strong brand and has proved one of the most defensive parts of the technology market in 2022. It has delivered consistent earnings, in spite of the consumer slowdown, demonstrating the inherent loyalty of its customer base and its pricing power even in tough markets. It has paid reliable dividends and bought back shares, cushioned by its substantial net cash position. Its reliability for shareholders has undoubtedly been enhanced by its long-term move towards service revenues, which are higher margin and recurring in nature. Apple increasingly provides an ‘annuity’ type revenue stream.
Microsoft has displayed similar characteristics, though its share price has been weaker. It has built a strong franchise, which has given it real pricing power through a tough climate and helped it see off a range of competitive threats. Its products are embedded within enterprises and have increasingly become a vital part of company’s collaboration tools. The diversity of its business has also been a key advantage.
There are areas that are defensive because they harness long-term structural trends. We would put cyber security spending in this segment. The value of cybercrime is currently $6 trillion, with predictions that it will rise to $10.5 trillion by 2025. That puts it just behind the economies of the US and China in terms of size or around 4x the size of Apple. It is expanding at 15% a year. That makes it one of the largest and fastest-growing enterprises in the world.
It is a focus for governments, corporations and private citizens. CEOs increasingly recognise that it is a non-negotiable part of their technology spend and will cut everything before scrimp on security. As cyber criminals grow more sophisticated, there is also a recognition that to achieve full security, organisations need a multi-layered approach. A single point of failure leaves the whole system vulnerable. This means organisations will use multiple providers.
We would also highlight semiconductors. Semiconductors were previously seen as the ultimate cyclical industry – in demand when demand for consumer technology rose, but left high and dry as economies weakened. However, the landscape has changed with semiconductors now a crucial part of the evolving technology landscape – for electric cars, or for data analytics, for example. They have become the building blocks of the modern economy, which gives them a reliable demand profile and growth trajectory.
Governments recognise their role in long-term technology supremacy. In the US, the government has made a $50bn commitment to semiconductor manufacturing under the CHIPS and Science Act. In October, the US Commerce Department sought to protect its domestic supply further, with the announcement of export controls and added more Chinese corporations to its ‘unverified’ list. This makes it more difficult to bring in semiconductors from outside and use them in US manufacturing and for US-made chips to leave the country.
It will take time for the new semiconductor landscape to take shape and for the winners and losers to become clear. Within the portfolio, we have shifted our semiconductor exposure – with less exposure to some of the ‘commodity’ semiconductor companies (those that make generalist chips), and greater focus on those companies making specialist chips.
Companies may have slowed their digital adoption in 2022, they have not halted it. Satya Nadella, chief executive of Microsoft, said in the group’s latest results announcement that the digital adoption curves seen since the start of the pandemic were not slowing down: “They’re accelerating, and it’s just the beginning.”
CEOs are ruthless about looking at technology as ‘nice to have’ and necessary to have’. Companies that improve a company’s productivity, its profitability or its competitiveness will have a market in all conditions. This is why CWC Corporation and ServiceNow have been resilient this year.
Of course, there are exceptions. There are still some parts of the technology market that are notably stronger in a growth environment. While the upgrade cycle may not be as pronounced, companies are still inclined to try new technologies when they have more cash to spend. Consumer-related technology – PCs, handsets – all tend to slow in a weaker environment.
Equally, in a climate where the cost of borrowing is rising, companies with high cash burn and no clear path to profitability will struggle. There will be times when the market ‘tolerates’, even encourages, this type of company, but it will be unforgiving in a weakening market environment.
Technology is a sector that requires investors to stay on their toes: it used to be that hardware was important, but now people are buying their server capacity in the cloud. Data centres are relevant, but storage, previously a huge industry, is no longer significant. Technology is a vast part of the global economy and has its tentacles in a lot of different industries. Its characteristics shift over time, and investors should be wary of thinking it can only play one role in a portfolio.
