Where technology stocks go next after a tough year

Low valuations for technology stocks make the sector more attractive than a year ago, but economic challenges remain. 

Technology investors have suffered one of their most painful years in recent memory, with the FTSE World Technology index down 25% this year in sterling terms and 31% in dollar terms.

Caught up in the sell-off has been Polar Capital Technology, the £2.5 billion investment trust. Its shares have fallen 35% this year, and it currently trades at 10% discount to the value of its net asset value (NAV). Its half-year results, released today, showed that its NAV fell 9.1% in the six months to 31 October 2022, compared with an 8.9% drop for its technology benchmark.

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Ben Rogoff, who manages the trust, says that the outlook is tough for the tech sector and markets more generally.

He said: “There is little to obviously like about the immediate market outlook: slowing growth, record inflation and central banks embarrassed by how far inflation has surpassed their long-term targets.

“In terms of downside risks, the most prominent remains inflation, should it not come under control. There are also more structural issues to contend with relating to a structural shortage of labour in many areas of the market and shortages of production capacity in key commodities.

“Further energy shocks or the impact of pent-up Chinese demand upon reopening could result in incremental upward pressure on inflation, and as such monetary policy may still surprise to the upside or remain restrictive for longer than markets are currently anticipating.”

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The combination of higher interest rates (which increases the return from risk-free investments), slowing growth and pressure on profit margins makes the technology sector less attractive.

Nevertheless, Rogoff does offer some reasons to be cheerful. First, he says that the US economy, which is the most important market for tech companies, is stronger than many realise.

“While economies in the UK and Europe are already likely contracting, a US recession is not a foregone conclusion. Although a recent Wall Street Journal survey of economic forecasters estimated the probability at 65%, Goldman Sachs believe the chances are nearer 30%.”

Second, Rogoff argues that we may have already seen peak inflation, which could allow the US central bank to slow its interest rate hikes, which would boost valuations of tech stocks. Inflation in the US in October came in at 7.7%, which was below estimates.

Rogoff said: “While we know one CPI print does not make a pivot, there is still a case that the US can avoid a recession as monetary policy could soon be sufficiently restrictive to see inflation trending back down towards 2% with only a modest increase in the unemployment rate.”

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Elsewhere, China may also become an unlikely source of optimism next year, Rogoff says, if it relaxes its zero-Covid policy.

“This could be a countervailing force to sagging global demand, US/China relations could thaw as Biden and Xi have shored up their own political positions, and - most important of all - there could be a de-escalation of Russia/Ukraine tensions,” the tech investor said.

Another pocket of optimism comes from the valuations of tech stocks, which are much more attractive than a year ago.

Having peaked in November 2021 at 28 times, the forward price-to-earnings ratio of the technology sector has fallen significantly over the past year. Today the sector trades at 21.3 times. This is below the five-year average (21.8x) but above 10-year (18.6x) average, points out Rogoff.

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He adds that software stocks are also far cheaper, and are actually at around half the valuation of before the pandemic on some metrics.

Rogoff said: “A year ago, there were 25 software-as-a-service companies trading at more than 20 times forward sales. Today there are none. The highest growth cohort (those growing >40%) recently traded at 11 times forward sales versus their 52-week high of 41.1 times.

“Overall, cloud software has recently traded with a median next 12 months revenue multiple of just 4.4 times versus the 2010-20 pre-Covid multiple of 7.8 times.

“As such (and all things being equal) we see much improved risk/reward in this group of stocks and have been moving the portfolio in this direction.”