Earnings Surprises Driving Tech Stocks Higher

 In Market and Investment Insights

Key Takeaways

  • We see further upside to tech stocks, not due to multiple expansion, but to the market continuing to underestimate earnings growth.
  • A generational shift in the breadth of technology usage – and its capabilities – is behind recent earnings surprises and we expect this favorable trend to continue.
  • The financial sector, media applications, China and online gaming are markets that should diversify sources of growth beyond traditional corporate users of technology.

Global technology stocks delivered stellar returns in 2017, far outpacing the broader market. We attribute technology’s strong run to a stream of consensus-beating earnings reports, which reflect the underlying health of the sector. For several quarters, we have held the view that, despite recent gains, tech stocks have additional upside, not due to further multiple expansion, but rather to the market continuing to underestimate the opportunity presented by the generational shift occurring within the sector.

Broader End Markets Should Lead to Less Earnings Cyclicality

Driven by the rapid deployment of the cloud and the Internet of Things (IoT) – two of our favored themes – and with the adoption of artificial intelligence (AI) acting as an accelerant, technology earnings, in our view, will continue to exceed market expectations. Furthermore, the increasing breadth of end uses for novel applications stand to dampen the sector’s historical cyclicality, providing a greater level of resilience for many companies’ earnings power.

Our long-held adage that “every company is a tech company whether it realizes it or not” is on display across the economy. Applications software companies, for example, allow firms in all sectors to leverage technology to drive sales as they shift from back-office to front-office spend. By harvesting the operational efficiencies gained from software, management team are freed to allocate more funds toward revenue-producing sales and marketing functions, thus creating a virtuous circle.

Despite last year’s rally, we view tech valuations as fair due to the concurrent rise in better-than-expected earnings for many companies. And while some companies that we have historically favored because of the resilience of their earnings are trading at higher than normal valuations, we believe they are still attractive thanks to their long-term growth potential.

Diversifying Tech Exposure with Uncorrelated Themes

In addition to potentially benefiting from consensus-beating earnings growth from sector luminaries, investors, with the appropriate risk tolerance, can take other steps at this juncture to potentially optimize the return profile of their technology allocation. One method is to incorporate uncorrelated stocks. These are companies that tend to rely on end markets different than other tech companies such as data services business for the financial sector or media companies. Other sources of growth that have lower correlations to our favored themes are the rapid digitalization of China’s economy as well as the global growth of online gaming. We believe exposure to these growth stories – and adjusting opportunistically based on the valuation and risk profile of each theme – will provide investors with desirable characteristics in a technology allocation.

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