Technology rally: four key points to bear in mind

By: Tomasz Godziek, Head Thematic Equities, Huseyin Turan, Portfolio Manager & Joran Mambir, Investment Specialisten at J. Safra Sarasin Sustainable AM.

Tech stocks have gained popularity in recent years, and for good reason. The sector has outperformed the overall stock market by over 800% in the last 15 years. With favourable tailwinds that are driving technology spending higher for the next few years. The trend is set to continue. Here are four things to consider when investing in technology.

Why will technology companies continue to outperform?

The technology sector has many advantages over the broader market that make it more attractive today than ever before.

Firstly, tech is exposed to some of the most attractive long-term growth trends, such as artificial intelligence (AI), new semiconductor architectures and cybersecurity. In addition, other new disruptive technologies, such as quantum computing and autonomous driving, are just around the corner and will drive the sector's growth in the future.

Moreover, technology companies are also highly profitable and enjoy the highest levels of operating margins with high levels of recurring revenues. On average, companies in the MSCI World Information Technology index have operating margins of 21.5%, compared to 12.5% for companies in the MSCI World index. Moreover, technology companies are continuously improving their margins. The era of "growth at all costs" has come to an end, as technology companies are now more focused on profitable growth.

Technology investments have also become a priority for governments, given the growing geopolitical tensions and supply chain problems that came to light during the pandemic. Technology investments became a national security issue, as nations around the world rushed to boost domestic semiconductor manufacturing and bolster their own cybersecurity defences. The technology sector is therefore in a unique position, as its companies are benefiting from increased spending by consumers, companies and now governments as well.

Beyond sector-specific reasons, the macroeconomic outlook also favours tech, as most central banks - with the exception of the Bank of Japan - are expected to ease monetary policy in 2024. This is good news because interest rates have been a headwind for tech valuations since early 2022. Now that peak rates are behind us, the sector should benefit from a tailwind of more benign monetary policies.

Are we witnessing another tech bubble?

The companies leading the tech rally today are a far cry from those that led the dotcom bubble in the late 1990s. Artificial intelligence giant Nvidia is trading at 30 times next year's earnings (matching its ten-year average). By contrast, many dotcom-era companies were valued at 100 times earnings and many were heavily indebted, while others were loss-making. Today's large technology companies have very high operating margins and free cash flow margins, with healthy balance sheets. They also have global end markets that are easier to expand, whereas the major dotcom companies were mostly telecommunications companies operating in regional or national markets.

What are the biggest risks for the technology sector?

While technology stocks offer great growth potential and high returns, they also carry a certain degree of risk. One such risk is geopolitical turmoil, as conflicts are increasingly interconnected and could easily spread to other parts of the world.

De-globalisation due to geopolitical risk has been positive for the technology sector, as it is leading to offshoring and friendshoring, i.e. the shifting of supply chains to countries that are political or economic allies. However, markets could still suffer in the event of a major escalation of the conflict.

On the regulatory side, big tech companies face stricter rules on mergers and acquisitions, data privacy and antitrust issues.

There is also the risk of AI "hype" in the short term. There are high expectations for AI and its potential to revolutionise the global economy. However, it is still in its infancy and many companies are often cautious about adopting new technologies. This may delay the rapid and widespread adoption of generative AI across all sectors.

How will AI shape the world, and how will it affect investment?

Artificial intelligence is nothing new. Alan Turing proposed his "Turing test" in 1950 to assess whether a machine could think. Since then, machine learning has continued to evolve, leading to the next big step: generative AI. However, the real driver of AI is the rapid increase in the processing power of computers, driven by the huge innovations in the semiconductor field in recent years. This is about to usher in a new golden age for AI, as capital continues to pour into the field.

Generative AI is still in its early stages, and while we can already see how it can be used in many applications, there are undoubtedly many more where AI will have a significant impact that we do not yet know about. Thanks to generative AI, many industries will see productivity gains and cost savings. Customer service, for example, is already feeling the effects in a big way with increased reliance on chatbots, multilingual support, augmented messaging and data-driven decision making.