10 momentum plays in the UK technology sector

Economic headwinds triggered a major sell-off in technology shares last year, but with ‘big tech’ building momentum again, is it time for investors to revisit the sector?

After more than a decade leading US markets to higher highs, ‘big tech’ suffered some brutal lows in 2022. Savage pull-backs in some of the world’s largest stocks showed how investors had become wary of paying racy prices for the promise of future growth.

Inflation, rising rates and economic pressures led to a weaker earnings outlook for tech firms. Those with models reliant on advertising revenues and buoyant consumer spending were the hardest hit.

• Invest with ii: Top UK Shares | Share Tips & Ideas | Cashback Offers

In the bloodbath, Tesla Inc (NASDAQ:TSLA) stock fell by 65%, Meta (NASDAQ:META) fell by 64.2%, NVIDIA (NASDAQ:NVDA) fell by 50.3%, Amazon (NASDAQ:AMZN) fell by 49.6%, Alphabet (NASDAQ:GOOGL) fell by 38.7%, Microsoft (NASDAQ:MSFT) fell by 28.7% and even Apple (NASDAQ:AAPL) fell by 26.8%.

Given that these companies were previously valued at hundreds of billions (and even trillions) of dollars, their faltering fortunes had a large relative impact on the market.

These charts (below) from Schroders show how the ‘big 7’ tech stocks in the US led the market higher in 2020-21, then lower in 2022 and are once again outperforming in 2023:

Past performance is not a guide to future performance.

Is the tech sector becoming more investor friendly?

Some commentators think last year was a watershed moment for larger shares in the tech sector. After years of having cheap money available to fund lavish projects in the name of growth, there’s a sense that some firms are (or should be) maturing. In the face of tougher conditions, investors are becoming much more interested in efficiency, profitability and positive cash flows - and, whisper it, even dividends.

Here in the UK, the tech sector is a much smaller part of the overall market. At the larger end, there are around 10 firms in the £1-10 billion bracket. A couple of them qualify for the FTSE 100, with most of the largest companies found in the FTSE 250. In terms of numbers, the bulk of the sector sits in the Alternative Investment Market (AIM).

• The pros are ditching commodities for tech stocks
• Watch our video: the US shares we own that will outperform Big Tech
• Artificial intelligence: is the hype real, and how to invest in the winners

Despite having different dynamics to the US, UK quoted tech shares saw similar trends last year, with most stocks suffering double-digit price declines. And while many are still in negative territory on a one-year basis, there are signs that some in the sector are capturing investor imagination.

This week I have taken a snapshot of the tech sector with a focus on the strongest price performances in the first five months of 2023. The results are limited to stocks with a market cap of more than £100 million, which strips out most of the speculative and unprofitable plays.

With one exception - IQGeo Group (LSE:IQG) - I have included rules that look for positive forecast earnings growth, positive return on capital employed and positive operating margins, as clues to firms that are profitable and have established businesses. The table also shows the forecast price-to-earnings ratios of these shares.

Data: SharePad

IQGeo is an exception because it wasn’t profitable last year, so has a negative Return on Capital Employed (ROCE) and operating margin. However, it is interesting to include because it is forecast to see its earnings grow and turn positive this year, which means it does have a forecast price/earnings (PE) ratio. You can see that at 50x forecast earnings, and a strong price trend year-to-date, investors are willing to pay up for slightly more speculative growth in small tech shares like this.

That said, the rest of the list largely tallies with the argument that the market is preferring larger, more profitable firms perhaps with more modest growth expectations, and coming with more moderate valuations. That doesn’t mean they are all fairly priced, but neither are there widespread sky-high PE ratios in evidence.

Some of the biggest UK-quoted tech names have seen strong moves this year, including Moneysupermarket (LSE:MONY), Bytes (LSE:BYIT), Auto Trader Group (LSE:AUTO), Sage (LSE:SGE) and Darktrace (LSE:DARK). Darktrace is showing a quadruple-digit EPS growth expectation this year as it finally shifts from loss-making to profitability.

Other observations from the results are the strong operating margins that are generated by Auto Trader and Baltic Classifieds (LSE:BCG) - 69.5% and 75.6% respectively. Both firms make money using a model of online classifieds, which can be a very low-cost, high profit business.

• 10 great UK shares that Warren Buffett would pick
• 10 quality mid-cap shares with promising momentum

Another point is the strong earnings per share (EPS) growth forecast at Sage, the accounting software group. Sage is the largest company here, with a market cap of £8.8 billion. Its EPS came in at 25.5p in 2022 and is set to grow by 20% to 30.7p in 2023, which again shows that size is no hindrance in this sector when it comes to delivering strong profit growth.

A sector to watch in a recovery

UK technology shares don’t have the same huge influence on the market as their peers in the US do. However, their performance last year was similar, with even profitable firms seeing their prices fall sharply on gloomy economic news. This side of the Atlantic, many larger-cap tech stocks are in rally mode and beginning to recover lost ground or even break out to new highs.

Frustratingly slow progress on reducing inflation may cause investors to remain cautious on the sector. But if momentum in prices continues to build, it could spread further into the smaller-cap tech shares - making it a sector to watch as the outlook starts to improve.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.