There is no doubt that tech investors have had a tough time recently. Technology stocks have slumped in reaction to the surge in US 10-Year bond yields towards 1.75% in April, triggered by fears of a shift in central bank policy (rising interest rates) and a selloff in technology shares.
While ‘Mega caps’, such as Google, Microsoft and Amazon, have proven relatively resilient given the strength of their balance sheet and global dominance, emerging technology leaders such as Afterpay and Tesla have sold off more aggressively as investors lock-in profits after strong share price gains in 2020.
In the chart below, we can see the strong rebound in the US tech heavy Nasdaq 100 index off March 2020 Covid-19 lows. Continued bouts of profit taking following their stellar 2020 performance has left the index with little gain so far in 2021.
Many technology stocks have now fallen by 30% or more in 2021, and many investors are now wondering if a major correction in tech companies will continue for the remainder of the year. But rather than flee tech, Holon believes the recent selloff actually offers investors a window of opportunity to allocate more of their capital into global technology stocks at attractive prices.
The world’s leading innovators offer investors strong long-term earnings growth over the next decade as their investments into new technology platforms, including blockchain, digital money, cloud storage, artificial intelligence and autonomous transportation, become more widely adopted globally.
Indeed, as highlighted in the recent reporting season, there are 3 key reasons why Holon believes investing in innovation remains the lowest-risk opportunity to generate excellent long-term investment returns.
1. The Covid-19 Dividend drives strong earnings results
Over the past year technology stocks have posted exceptional gains. The tech-heavy Nasdaq 100 index almost doubled from the March 2020 lows. One of the main reasons for the surge was that Nasdaq-listed companies were the main beneficiaries of the Covid-19 dividend: the accelerated shift of businesses and people into the digital world.
Technology stocks reported strong results across the board during the recent Q1 2021 U.S. reporting season. Google (Alphabet) for example, reported a 162% rise in Q1 earnings, while reported earnings per share (EPS) growth surged 162% over the last 12 months.
Alphabet’s low Q1 2020 results, depressed from the Covid-19 lockdown, did overinflate comparable growth rates in the last quarter, but Google’s results were substantially stronger than market analyst’s average EPS growth forecast of 66%. A beat of this size in one of the world’s largest companies is rare, and indicates that most financial analysts misunderstood the acceleration of exponential growth as we all shifted more of our life online.
A local Australian company that continues to baffle local analysts is Afterpay, which recently reported stellar sales growth in the US and UK of 211% and 277% respectively. After a stellar 2020 share price performance, Afterpay has seen heavy profit taking since March 2021.
We believe that Afterpay, which offers younger consumers a payment alternative to traditional credit card options, is still at the start of its exponential adoption curve. Buy-now-pay-later service penetration reached 20% and 38% of the UK and US populations respectively in 2020. We remain confident that Afterpay’s offering can deliver robust earnings growth over the long-term as they build market share in retail markets much larger than its Australian base.
Yes, some technology companies were overpriced prior to the most recent tech sell-off, but the strong earnings growth and long-term outlook shown in their latest quarterly results should provide investors with added confidence of strong share price appreciation ahead.
2. Tech stocks will be the long-term winners
Despite this Covid-19 dividend, investors have been buying ‘old world’ value stocks, particularly those heavily impacted by the global shutdown, in the wake of the reopening of the economy and the ongoing vaccine rollouts across the globe. And at the same time they have sold down some of their Covid-19 dividend winners.
These investors believe that ‘value’ stocks offer a safer investment with technology in a ‘bubble’ and global inflation fears rising.
But we think the safest way to generate sustainable, long-term returns is to invest in companies that consistently generate long-term earnings growth.
That means identifying companies that operate with long-term structural tailwinds, such as rising cloud adoption, digital payments, and Web 3.0 innovation. We then identify the unique value proposition that each company offers to consumers. For example, Coinbase, one of our recent investments, offers a strong value proposition for companies using its digital infrastructure to develop Web 3.0 applications that are regulatory compliant and in an institutional grade custody environment.
By contrast, ‘old world’ business models face significant headwinds given their generally poor balance sheets, which means they don’t have enough funds to invest into the digital infrastructure needed to compete effectively in the digital global economy.
Uncertainty also remains high amongst traditional ‘old-world’ names, particularly in a rising interest rate environment that would require higher interest payments on big debt levels that would negatively impact earnings.
We believe most sectors can’t generate sufficient long-term returns in the face of rising disruption from global innovators. So what may appear as less risky (investing into the ‘old-world’) because of lower price volatility is actually riskier over the long-term than a portfolio heavily weighted towards global technology leaders.
3. Valuations look attractive following recent selloff
The third reason that tech stocks are attractive now is valuation.
Holon adopts a conservative approach to value global innovators. We start by forecasting our most likely estimate for a company’s performance out at least 10 years, and then discount the value of each year’s free cash flow by 10% from the previous year. Some would argue that a global risk-free rate (US 10yr bond) below 2% could allow us to lower our discount to 7-8% (which would raise our target prices for our investment universe by 50-100%), however we remain anchored to a more conservative 10% rate.
Following the tech sell off over the past few months, we see substantial long-term price appreciation and investment value for investors.
Take Apple for example. It currently trades at 18x 2021 PE multiple (ex cash), close to the valuation of Australia’s leading banks. Apple is extremely well placed as a leading global innovator, and will likely maintain over 25% annual sales and profit growth over the next decade. With $163 billion of net cash, they have the immense balance sheet strength needed to fund new innovation opportunities in blockchain, AI, digital payments, digital health and education.
As a key beneficiary of our accelerated shift online. Apple shares doubled within 6 months of the Covid-19 March 2020 lows. Apple’s share price has however consolidated since September 2021. Strong continued earnings results and a possible announcement of its plans with digital payments (cryptocurrencies) are likely catalysts for a strong share price breakout in 2021.
Australian banks on the other hand are recovering from a recent royal commission into their banking practices. As a result they have been forced to raise substantially more capital to protect deposits, lowering returns and restricting their flexibility to engage with innovative customers. As a result they face intense competition from global digital payment rails that completely usurps the need for banks in B2B and B2C transactions. Long-term earnings prospects look low (at best) for Australian banks over the next decade.
A rare opportunity
The recent tech sell off has been sharp and painful. But given the factors above, we don’t see significant further share price falls for the remainder of the year.
Indeed, now is a great entry level for investors to go overweight in their exposure to innovation. This exposure would include the leading global innovation companies such as Amazon, Google, Tencent and Alibaba, alongside tomorrow’s champions in Tesla, Afterpay and Xero. Each offers a substantially better investment return horizon relative to most traditional ‘old-world’ value investments.