By Brad Slingerland and Denny Fish
Global Technology Portfolio Managers Brad Slingerlend and Denny Fish discuss why a focus on the long-term themes that have a strong chance of driving tech sector performance for years to come is favorable to obsessing over the short-term volatility inherent in financial markets. However, investors must determine what sources of volatility are mere noise and which others may change an investment thesis.
The trajectory of the technology sector has been pivotal to that of global equities this year, first driving January's market gains, and later weighing on broader shares, due to a possible increase in regulatory scrutiny. While the volatility that accompanied the latter development might raise the heart rate of generalist investors, we believe that the best way to navigate bouts of turbulence is to maintain a disciplined focus on sector fundamentals, and these remain strong, especially for companies associated with the themes that we believe will dominate the tech landscape for years to come.
A Mismatch of Earnings Expectations
As illustrated by recent earnings reports, a specific set of high-profile themes continue to build momentum. The cloud, the Internet of Things and the enhanced data analytics made possible by artificial intelligence (AI) are forces that, in our view, will reshape how businesses and consumers interact with technology. The complementary nature of these themes should help propel a virtuous circle, creating more opportunity for the Software as a Service (SaaS), semiconductor and analytics companies delivering the next generation of technology products.
To a degree, the dynamics that have recently propelled - and buffeted - the sector serve as a reminder of why an eye toward the horizon is an advantageous strategy for tech investing. We believe deep, fundamental company and sector analysis is necessary to identify themes that stand to reshape how enterprises use technology. These shifts tend to play out over years rather than months or even quarters. Several SaaS firms, for example, continue to deliver consensus-beating earnings reports. Implicit in these surprises is that the market has yet to fully grasp the opportunity presented by the cloud. This mismatch of expectations is magnified by the long runway for earnings growth, as it is our view that we are still in the early days of a generational shift from on-premises services to the cloud.
Gauging the Sources of Volatility
A focus on a long-term investment horizon should also help weather the bouts of short-term volatility inherent in financial markets. It is, however, necessary to differentiate between "noise" and other factors that have the potential to alter an investment thesis. March's bout of volatility was largely the result of the rising specter of regulatory risk weighing on Internet stocks. While we believe the risks are manageable, we expect that the dispersion of outcomes for many of these companies has widened and, thus, investors should weigh the near-term risks associated with advertising-based business models to as compared to other promising tech segments, such as subscription-driven cloud services.
We accept that regulatory risk is out there, more so in Europe than in the U.S. While we don't expect online privacy to be a major focus of the Trump administration, we do consider it possible that Congress may enact legislation akin to Europe's General Data Protection Regulation, which goes into effect next month. The international competitive landscape is also a source of potential risk. There is the chance that the administration - through regulations or tit-for-tat trade skirmishes - places burdens on U.S. tech companies. Such eventualities could open the door for Chinese tech firms to take away market share from their more-established U.S. peers.
Identifying Risks, Seeking Diversification
The sector's recent path reinforces our view on the merits of actively managing one's technology exposure. The ability to underweight names that currently have an elevated level of risk - regulatory or otherwise - is a propitious tool to have at one's disposal, as is the ability to gain exposure to companies smaller than those in large-cap tech benchmarks. Allocations to private companies and firms outside the sector are also levers investors can pull to lower correlations to the broader technology market when conditions merit such steps.
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Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.
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