Disruptive technology in the COVID-19 era

Within
the global economy, COVID-19 has acted as a formidable accelerator of trends
driving disruptive technology. Valuations of information technology stocks have
soared, raising questions about the extent of the rally. Guy Davies, chief
investment officer for fundamental active equities, explains why this time may
be different.

COVID-19 has undeniably led to an
acceleration in select secular growth themes and, currently, there’s no sign of
that letting up. For instance,

1. Cloud computing
   • Agile working – the ability to access, process and be productive almost anywhere
   • Entertainment on demand – we can travel with our entire collection of movies, music, books, photographs and so on
   • Remote care and support – accessing healthcare systems or online medical consultations.
2. E-commerce and digital payments, reflecting people’s preference to shop from home and avoid using cash
3. Automation, both via software and physical robots, which enables more localised manufacturing in response to more strained global supply chains.

Hence, while there are valid reasons for
believing that there may be respite in the rally of those stocks that have
obviously been propelled by COVID-19 related factors, the secular change
associated with the cloud, AI and automation has much further to run.

The fundamental drivers of disruptive technology

Among the key factors driving disruptive
technology are innovation and motivation, but the fundamental driver in our
view is digital transformation. This makes existing processes more efficient
and enables new products and services, all of which are central in tackling
some of today’s most pressing challenges.

Some areas in which digitalisation can
help include:

1. Inequality – access to
   broadband can enable the provision of remote healthcare and improve financial
   wellbeing through online banking
2. Climate change – the
   datacentres that power the cloud require significant amounts of energy; solar
   and wind energy, which rely heavily on digital processes, could represent more
   sustainable long-term solutions
3. Healthcare – remote healthcare
   and telemedicine could help to increase the capacity of our healthcare systems.
   Similarly, artificial intelligence and data analysis can be used to predict and
   manage the spread of infectious diseases.

Valuations of tech stocks

On a historical basis, tech valuations are
high compared to the last 10 years, but in my opinion, these stocks do not look
excessively expensive when you look back 20-25 years. That is to say,
valuations are not beyond the sort of levels we saw back in 2000 during the
tech bubble.

Within the tech sector, valuations for
software stocks do look extended, but there’s also a lot of dispersion between
companies. Indeed, this is not a rising tide that has lifted all boats, there
are discrepancies and fragmentation in pricing between and within tech sectors,
which creates opportunities. I can point to certain stocks that look cheap –
based on growth in margins, market share and the net addressable market. Others
appear expensive – companies that are yet to make a profit or generate free
cash flow, but that are already trading on lofty valuations.

Hence, I think you need be company-specific and examine a range of valuation metrics (DCFs, PE, P/CF, growth rates and ROIC/CFROI[1]) for all companies – and most importantly the moats and sustainability of these growth rates and returns on capital. The leaders in each sector tend to have the best technology, but also reinvest the most for future growth. And this in and of itself becomes a virtuous circle.

A very particular context

Finally, it’s also important to consider
the context; in a low growth, low rates, low inflation world, how should we
value these global leaders?

It is already apparent that the COVID-19
crisis has launched a new cycle of low growth coupled with high debt burdens –
governments and central banks in developed countries have little choice but to
prop up the real economy by ensuring businesses have the funding they need.

As a result, some of these companies’
future profits will have to be set aside to repay debt. A low interest rate
world could arguably allow valuation multiples to remain high, even during a
cycle trough.

In this environment, only the best
companies, positioned in the few high-growth segments, and running their
business with sound capital allocation and without financial engineering tricks
to inflate earnings will be able to match these expensive valuation multiples
with earnings growth. In a world of predominantly low growth, this type of
growth will be the kind that lasts.

Financial value is therefore less likely
to be generated through asset allocation as it has in the last 30 years of
continuously declining interest rates. Instead, I believe stock picking will
come to the fore as the cycle of ever-lower interest rates ends and the gap in
performance between the leading companies and the rest of the pack widens.

Also
read

• Disruptive
  technology – The drivers and the challenges

[1] There are various methods of valuing stocks. Read more at https://www.investopedia.com/articles/fundamental-analysis/11/choosing-valuation-methods.asp

Any
views expressed here are those of the author as of the date of publication, are
based on available information, and are subject to change without notice.
Individual portfolio management teams may hold different views and may take
different investment decisions for different clients. The views expressed in
this podcast do not in any way constitute investment advice.

The
value of investments and the income they generate may go down as well as up and
it is possible that investors will not recover their initial outlay. Past
performance is no guarantee for future returns.

Investing
in emerging markets, or specialised or restricted sectors is likely to be
subject to a higher-than-average volatility due to a high degree of
concentration, greater uncertainty because less information is available, there
is less liquidity or due to greater sensitivity to changes in market conditions
(social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

Writen by Guy Davies. The post Disruptive technology in the COVID-19 era appeared first on Investors’ Corner – The official blog of BNP Paribas Asset Management.