During the “tech bubble”, the market saw the emergence of over-hyped companies with questionable business models.
These were often cash flow negative enterprises, not only unprofitable, but, in some cases, carrying zero revenue.
Today, in contrast, the technology sector is built on solid foundations, with numerous opportunities to provide sustainable solutions to global problems.
Rise of the tech super powers
The tech sector super powers of today are giants in the global economy, and boast a completely different scale to the industry’s previous hierarchy.
In 1995, only Microsoft featured in the top 10 listed US companies on the S&P 500 index, with approximately $500m devoted to capital expenditure annually. Today, Apple, Alphabet, Microsoft, Amazon, and Facebook all feature in the top 10 and collectively spend approximately $34bn on capital expenditures per annum.
As opposed to the blue-sky companies that collapsed on valuation delusions during the bubble, today’s tech giants are among the most profitable and cash generative in the market.
As a result, industry titans, such as Apple, Google and Microsoft, have amassed vast cash balances, which support continued R&D investments, as well as the acquisition of new technologies and competitors. For instance, Apple currently boasts a cash balance of $240bn – greater than the GDP of Greece.
Investor confidence underpinned by attractive valuations.
Meanwhile, investor confidence in technology companies has improved. Over the last five years to the end of December, the FTSE All-World Technology index has rallied by 85 per cent, outperforming the FTSE All-World index by over 30 per cent.
Performance of indices over 10yrs
Source: FE Analytics
The ability of companies to consistently grow sales and profits amid a period of sustained low economic growth has been a driving factor in the relative outperformance.
Valuation is also a factor. With rising sales, profitability and cash flow generation, the leading technology companies today trade at reasonable valuations on various measures relative to their historic levels.
The S&P 500 Technology index currently trades at around 16.5 times 12-month forward forecasted earnings, which represents a 2 per cent discount to the broader US market as opposed to the 4 per cent premium the sector has held on average over the last ten years.
Performance of indices over 1yr
Source: FE Analytics
During the bubble, this measure peaked at 51 times. As well as enviable balance sheets and rising investor confidence, the sector is also supported by considerable tailwinds for further growth.
Tech enables rising adoption and usage
Technology is an enabler of growth and change for every sector. For example, Industry 4.0 and the rise of smart factories, and cyber-physical systems, offers the potential for a step-change in reliability, safety, and productivity. Similarly, smart-cities will see greater optimisation of physical infrastructure via predictive modelling and real-time data collection.
Meanwhile, technological advancements in fields such as artificial intelligence and virtual reality, provide business opportunities in new markets and raise the competitive barriers-to-entry for technology companies with strong credentials in these fields.
A further potential tailwind is in the political realm. The new US administration tax plans include provisions for low-tax rates on foreign earnings repatriated to the US – to incentivise companies to bring their cash onshore.
With many of the major US technology firms holding substantial cash balances overseas, this incentive (if enacted) could lead to a significant amount of cash repatriated to the US for share buybacks, shareholder dividends as well as US-based M&A, research & development and capital expenditure, all of which have the potential to enhance the fundamentals of the industry.
Heightened levels of regulatory scrutiny
While, undoubtedly, the tech sector holds immense opportunity for investors, there are number of headwinds that must also be considered.
As the power and influence held by the world’s leading technology conglomerates has risen, so has public, media and regulatory scrutiny. For instance, Google has been under formal investigation for alleged antitrust violations by the European Commission since 2010 and Facebook faces a similar legal battle.
If found guilty of any wrongdoing, these companies could face substantial financial charges, as well as potential disruption to operations and competitiveness in order to adhere to reformed regulatory requirements. Investors can also expect heavy regulation of safety critical technology such as autonomous driving systems, which may hinder the adoption timeframe.
Protectionism threatens tech’s diverse global network
Unfortunately, there is another side to the political coin in terms of the Trump administration; implementing trade protectionist policies could restrict the ability for US companies to access overseas centres of technological innovation.
For example, the consumer electronics industry has deep partnerships with manufacturing and component companies in numerous Asian countries, such as Taiwan, China, and Japan. Meanwhile, Trump’s campaign focused heavily on curbing immigration, could also limit US technology companies access to a diverse skilled labour pool.
Thomas Fitzgerald is associate fund manager at EdenTree Investment Management. All views are his own and should not be taken as investment advice.