Top investors spot opportunity in ‘cheap’ tech

Time to cherry-pick high quality technology firms, professional investors tell Sam Benstead. 

Leading fund managers are taking advantage of the crash in technology share prices to buy quality companies at cheap valuations, with elevated dividends.

Tech stocks, which are typically highly valued versus their earnings but promise fast growth, have been hammered this year as inflation fears have taken hold of markets.

The FTSE World Technology Index has dropped 19% year-to-date, in sterling terms, as investors punished expensive stocks and sought refuge in inflation-resistant natural resources and cheap shares.

But because of the sell-off, that index now yields 1.1% and has a price-to-earnings (p/e) ratio, which compares a company’s value with its profits, of 17.8.

This p/e is similar to US shares (16.5) and global shares (16), but the tech index is forecast to grow earnings faster, at 13.5% earnings growth this year versus 11.6% for global shares, according to data from Fidelity International, the fund group.

Lower share prices suggest higher future returns and increases in dividend yields.

Bargain hunters

Terry Smith, manager of the giant £23 billion Fundsmith Equity fund, says the tech sector is now cheaper than the consumer staples sector in America based on how much cash they generate.

Writing to investors last week, he said: “The median free cash flow yield (a measure of cash generation compared with share price) on the 78 technology stocks in the S&P 500 is 4.6% and the mean is actually 5.2%.

“Conversely the equivalent numbers for the 36 stocks in the consumer staples sector are 3.8% and 4.6%. The technology stocks in the S&P 500 are actually now more lowly rated than consumer staples.”

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He specialises in buying “high-quality” companies that have protective moats around their businesses and can keep growing profits well into the future.

Smith has added US tech giants Alphabet (Google’s owner), Amazon and Adobe over the past 12 months. The portfolio has 27% invested in the technology sector and includes Meta Platforms (NASDAQ:META) (formerly Facebook) and Microsoft (NASDAQ:MSFT).

He adds that tech stocks have continued to perform well at a business level, despite high inflation and slowing economic growth.

He said: “It may seem little source of comfort at the moment but our companies continued to deliver decent underlying business performance in the first half of 2022. Last reported portfolio weighted average free cash flow per share ended June 2022 4% higher than in December 2021, equivalent to annualised growth of about 8%.

“Revenue growth was strong, bordering on very strong at some of our companies. Results reported in the first half of 2022 showed two-year top line growth — which we look at in an attempt to avoid confusion caused by the gyrations during the pandemic — of 48% at Adobe, 66% at Alphabet, 51% at Brown-Forman (NYSE:BF.A), 79% at Intuit (NASDAQ:INTU), 40% at Microsoft, 39% at PayPal (NASDAQ:PYPL) and 47% at Waters (NYSE:WAT).”

Cheap chips

Stuart Rhodes, manager of the £2.4 billion M&G Global Dividend fund –  a top-quartile performer among peers over one, three and five years – has been buying into the weakness in technology shares, including software giant Microsoft and semiconductor firms ASML, KLA and Broadcom.

Rhodes said these companies had strong discipline with dividends and were far cheaper than they had been over the past couple of years. Moreover, he argues that the semiconductor space is set to grow steadily as more and more of our world now requires computer chips to run.

His weighting to technology has gone from 15.2% in December 2021 to 20% in May 2022, and is now similar to the tech weighting now in the MSCI World Index, which is unusual for a dividend fund as tech firms tend to be concentrated on investing their profits rather than returning them to shareholders.

The flip side to increasing technology for Rhodes is to cut consumer staples. The sector has risen this year due to increasing demand for companies that can pass on higher costs to consumers because demand is sticky.

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Rhodes sold out of Procter & Gamble (NYSE:PG) completely this year and noted that one of the big questions his team was debating was around high valuations for consumer staples and low valuations for technology.

“We are actively buying technology. Microsoft, for example, is cheaper than some consumer staple stocks,” he said.

Kasper Elmgreen, head of equities at investment manager Amundi, says that his team of fund managers was starting to cherry-pick high quality technology opportunities, including semiconductor stocks in Europe and America’s tech giants.

“In Europe, we like semiconductors. Not only have they been hit hard due to the interest rate outlook, but they are cheap because they are listed in Europe rather than America. In the US, we like some of the FAANG stocks, which have established business models and generate lots of cash,” he said.

However, Elmgreen warned that not all technology was attractive and investors should be wary of unproven companies. Overall, he believes “growth” as a broad theme has further to fall and investors should tilt their portfolios towards cheaper “value” shares.

He said: “Be cautious on companies not making earnings or generating cash as they still have high valuations. Some things can fall a lot further even after already crashing by 70% from their highs. It is all about the starting valuation and whether some stocks can ever become profitable.”

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Software opportunities

David Older, head of equities at fund group Carmignac, said the most attractive part of the tech sector was software.

This is because of the natural defensiveness of the sector, he argues, due to its cloud-based subscription business model and pricing power. “These are ideal attributes in an environment of rising inflation and slowing growth,” he said.

Older calculates that software valuations are below their five-year average, based on p/e and sales to market-cap ratios.

He said: “The trend towards digital transformation is still in its infancy, with only 10% of corporate IT spending having moved to the cloud, a figure that is expected to triple by 2025.”