Spotlight on Technology Disruption
Harbor has the benefit of sharing thoughts and perspectives with a diverse set of asset management partners around the globe – up and down the market capitalization spectrum, across different styles and geographies – we can go anywhere.
Our focus in this ProActive update is on the technology sector. More specifically, how we are identifying companies poised to deliver superior levels of longer-term growth within a backdrop of increased volatility. Joe Duffy, Director, Investment Specialist at Harbor is fortunate to be joined in this virtual conversation by three experienced growth asset managers: NZS Capital, LLC, Sands Capital Management, LLC and Jennison Associates, LLC.
Joe Duffy (JD): Market volatility has continued to be influenced by shorter-term corrections within technology stocks, as well as high volatility and momentum stocks. Most recently, elevated levels of inflation, the Fed’s potential unwinding of quantitative easing, and reduced domestic delta variant cases pushed U.S. 10YR Treasury yields higher and prompted a sharp pullback in information technology share prices. Over the past year, valuations in the technology sector have fallen while growth expectations have continued to trend higher. In fact, forward looking price-to-earnings estimates (FY1) for technology companies within the Russell 1000® Growth Index (“the index”) have fallen from 36.6x as of 9/30/2020 to 31.5x as of 9/30/2021, a 14% decline. Over the same period, consensus 3-to-5 year earnings per share growth expectations for Russell 1000® Growth technology stocks rose from 15.3% to 18.6%, marking an increase of nearly 22%. Given these fundamental changes, what are your thoughts about this segment of the market for the remainder of 2021 and beyond?
Source: FactSet, 2021
Brinton Johns (BJ): Markets remained focused on the key issues of the pace of a post-COVID recovery, the prospect of inflation and its implications for rates, and on the overall valuation of markets. In many cases, we think the concerns are overblown, but this combination of factors naturally leads to a period of volatility, especially recently. Our outlook remains positive as we view volatility as opportunity, not risk. We recognize there are parts of the market that are expensive, but we are finding compelling and attractively priced long- term opportunities in companies that meet our focus on innovation and disruption. The powerful analog-to- digital economic transition is a compelling backdrop for our portfolio, we believe. While we recognize market concerns on inflation and rising rates, we are less worried than most. We see the spread of technology and the increasing pace of innovation as a dampener on inflation as we move into 2022 and beyond. As a result, we are reacting to the opportunities that short-term fears bring rather than letting them change our optimistic vision about the future.
Sands Capital (SC): We believe history shows us two things: stock prices tend to track compounded earnings growth over the long term, and most value creation in the market accrues to a select group of companies. In macro events by shrinking time horizons and raising discount rates in their models. This can create volatility for long-duration assets, including high-growth innovative businesses. However, over longer time frames, we expect business results to be the primary determinant of share prices. Therefore, we focus our efforts on finding the select few companies that can generate sustainable above-average earnings growth for the next five years and beyond.
We believe the technology sector—with a focus on disruptive innovation—is fertile ground for seeking these companies. We live in a period of accelerating change, enabled by the proliferation of mobile and cloud computing as well as the sustained march of Moore’s Law. Nearly every part of our personal, consumer, and professional lives is becoming digitalized, which we believe creates a significant opportunity for entrepreneurs who can leverage technology to upend the status quo. We see a wide range of opportunities for disruption and subsequent wealth creation such as the continued proliferation of ecommerce around the world, a modernizing of enterprise software, the rise of artificial intelligence and machine learning, and the continued digitalization of our consumer lives.
Natasha Kuhlkin (NK): Large-cap technology stocks were among the strongest performers during the COVID- driven lockdowns of 2020, as the shift in consumer and enterprise behavior in favor of online shopping and work-from-home business models accelerated. Many of the e-commerce, cloud, and software-as-a-service (SaaS) companies that reported strong operating results during the pandemic are now facing challenging year-over-year financial comparisons. While this may be a headwind to share prices in the short term, we believe the developments of the past 18 months have accelerated the trends already in place prior to the arrival of COVID-19 and that the step-up in growth in these areas will prove durable.
We focus our research efforts on identifying companies likely to deliver higher growth that lasts longer than the market expects. We are currently witnessing a genuine transformation of the economy through technology, providing rapid growth for innovative companies throughout the value chain – from semiconductors to cloud data managers to software solutions enabling everything from digital payments to ubiquitous communication with customers. The challenge for investors is to evaluate the companies operating in these areas to identify the players with the business models and management teams most likely to capitalize on the opportunity and build significant scale over time.
JD: As economic conditions continue to recover in the post-pandemic landscape, investor concerns have risen regarding the potential effects of elevated inflation. Supply disruptions have widely been classified as “transitory” pressures. However, impacts such as stubbornly slow increases in labor force participation have raised expectations for higher inflation persisting over a longer-term horizon. Given implications for semiconductor companies and other industries, what is your team’s assessment of inflationary impacts across the information technology sector?
BJ: We agree that the supply chain issues are temporary. Predicting the timing to resolve issues is difficult but we do not see a long-term structural reason why we should continue to have shortages or production issues. Inflation is a concern, but we think that technology is part of the solution in terms of productivity improvements and better supply chain management. Companies may reevaluate their supply operations, consider greater integration and reassess their vulnerabilities to a just-in-time outsourced model. But these changes are not inherently inflationary once they work through the system.
SC: Like everyone else, we are seeing signs of inflation across many products and industries. Whether this proves transitory as consumer balance sheets and global supply chains normalize post-pandemic, or becomes structural, remains to be seen. Our general view on information technology is that global digitalization, cloud computing, Moore’s Law, and an interconnected supply chain are powerful deflationary forces. However, there can be cycles even within secular trends, and we can expect periods of market turmoil when the rate of change accelerates relative to prior expectations.
We don’t pretend to be able to predict the path that inflation will take over the short, medium, or even long term. Our expertise, we believe, is in identifying a small group of the highest-quality businesses that can make their own weather in any environment. We look for traits such as market leadership, pricing power, and business-model strength that we expect will help select business outperform regardless of the market environment.
Diving deeper into the impact on specific IT sectors, we think many of these businesses should be largely immune from structural inflation concerns. Many of the companies we own are IP-driven and build and sell digital goods at high incremental margins with low capital expenditure requirements. The majority of these do not face cost inflation from energy, raw materials, supply chain pressure, or generic labor. The primary way we see inflation for these businesses is in the war for talent, especially for high-quality developers and engineers. However, this is a continuation of a trend we’ve observed for over a decade, rather than a new phenomenon. We may even see some modest alleviation as remote work makes it easier to hire on a global basis and in lower-cost regions. We also believe top talent will continue to accrue to the strongest businesses who can offer better compensation at lower risk for employees.
Elsewhere, we do see inflation in the semiconductor space as Moore’s Law becomes more complicated (and therefore more expensive) to advance at a time when the demand for compute power will continue to rise dramatically. Therefore, we believe that businesses providing enabling technologies to meet this demand— such as Lam Research’s deposition and etching tools—will extract an increasing share of the value created.
NK: Inflationary pressures have taken hold throughout the economy, exacerbated by the effects of the pandemic lockdowns, stimulative fiscal and monetary policies, and the stumbling blocks created by the uneven pace of global economic reopening. Should higher inflation prove to be more persistent than expected, we could foresee a mixed result for technology stocks. On the risk side, higher inflation would likely lead to higher long-term interest rates, resulting in lower price /earnings multiples, which could pressure the valuations of long-duration growth technology stocks. Conversely, increasing cost pressures would add to the compelling case for cost-saving technology solutions, from outsourcing data management to boosting a company’s remote work capability to mitigate costs.
Significant supply constraints in semiconductor components, on the back of widespread production disruptions in 2020, are impacting industries that rely increasingly on the use of silicon, at a time when the semiconductor industry itself was struggling to meet pre-pandemic demand. The widespread effects have been seen across all manner of consumer and industrial companies. Leading semiconductor companies are investing heavily in new capacity to address the current shortages, and we are starting to see lead times on new orders decreasing slightly. While bottlenecks persist in the short-term, we believe semiconductor manufacturing supply will be sufficient to meet the growth in demand in the long term. This will lead to lower costs for customers, as returns to scale and incremental manufacturing capacity regain the upper hand.
JD: China’s regulatory crackdown on technology companies has raised investor caution and erased billions of dollars in market value from the country’s technology leaders. Given this situation combined with increasing geopolitical tensions between the U.S. and China, how has your team’s evaluation of the foreign technology investment landscape changed? What implications does this situation pose for technology companies domiciled in the United States?
BJ: Naturally, China’s government has held an important influence on the corporate sector for years, but the recent examples of intervention have been troubling. We remain cautious about the operating structure for Chinese companies and the treatment of shareholders. We do not think valuation alone is enough to move into China without signs of a more favorable treatment of investors. The risk is not only to stock market investors but extends to U.S. companies investing resources in the growing Chinese market. Outside of China, however, we continue to look at non-U.S. companies for investment opportunities. While it appears to move in waves, the center of innovation currently appears to be the U.S, and we have found most of our investment opportunities in America.
SC: Around the world we are seeing regulators, politicians, and often the general public concerned about topics such as monopolistic practices, data privacy, and misinformation when it comes to large technology companies. This played out in rapid fashion in China this year where regulators have more power to enact change relative to a market like the United States. While it is difficult for anyone outside of the Chinese government to know what regulatory issues it will focus on next, we think it is likely that additional regulatory pressure will follow, especially for consumer internet companies that may not be deemed as supporting common prosperity and China’s Five-Year Plan. We think this puts a higher discount rate on China for global investors, and valuations of affected companies are unlikely to rebound near term. It likely adds interest to tech companies in other emerging markets (Latin America, India, Korea, etc.), which may boost multiples.
We do not view this as a canary in the coal mine for more aggressive government action around the globe. Big-tech regulation is not a new issue in the United States, and one that we’ve analyzed and navigated for years as growth investors. We are monitoring the potential for legislative action to strengthen the antitrust laws (which historically have used the precedent of consumer harm) and to directly regulate tech platforms. However, given the realities of the legislative process and competing policy objectives, we think small changes—such as requiring Apple to allow alternative payment mechanisms in the App Store, or limiting Facebook’s ability to make future acquisitions—are most likely in the near term.
NK: The interventions by the Chinese government in a number of sectors over the past year have undermined investor confidence and clouded the profit picture for Chinese corporates. As fundamental investors focused on long-term growth and profitability, we are not comfortable with the lack of visibility and the risk of further government action. Therefore, our portfolios have no direct exposure to Chinese stocks at present, and we plan to remain on the sidelines, awaiting greater clarity.
We do not believe the regulatory backdrop in China is having a material impact on U.S. tech companies doing business in China. In fact, many of the chips and components sold to Chinese customers are critical to China’s growth and innovation. As an example, Nvidia’s advanced graphics chips are the “go to” solution for the AI activities of China’s largest companies, something we believe the government is incentivized to promote, rather than disrupt.
JD: As the digital revolution continues to gain momentum, companies are rapidly adapting their business models to survive. What are some of the key disruptive themes that are playing out within the information technology sector and how is your team seeking to capitalize on these emerging trends? How do you assess earlier-stage, transformative companies as you evaluate potential holdings for your portfolios?
BJ: As your question suggests, the key to innovation is adaptability. Innovation brings about unexpected change. The key is to find companies that can adapt to that change quickly or that are enabling the change. In terms of adaption, we are looking for companies that can replace firms that are stuck in old ways and unwilling to sacrifice near-term profits to reinvent. Our preferred holdings tend to be decentralized, agile businesses showing what we refer to as “Non Zero Sumness” (NZS for short). NZS means win-win, that a business is providing more value to its customers than it is taking. If a firm does not do that, another firm will, and the digital age allows customers to switch more quickly and easily than ever. Disruptors fighting slow incumbents exists across the economy, but examples include payments, real estate, restaurants, and retail. Incumbents in these areas are finding their competitive moats are barriers to their own growth, not benefits. In terms of enabling, we think semiconductors remain the foundation of the massive analog-to- digital economic transformation we are experiencing. The industry has developed a broader customer base and become less cyclical than the market seems to reflect.
SC: We believe we live in an exciting time full of disruptive innovation and change. Every element of our lives is becoming digitalized as mobile and cloud computing dramatically increase the scale of opportunity for IT businesses. The continued progression of Moore’s Law, rise of cloud computing tools, and availability of venture capital has led to an explosion in the number of new technology businesses that have the potential to scale faster than before. This, in turn, has enabled new businesses and business models that can create new markets from scratch and/or disrupt legacy incumbents; for example, Square’s Cash App in consumer banking, and DoorDash in food and goods delivery.
This dynamic has forced a technological awakening from businesses of all sizes and across all verticals, in our view. Every business needs to rethink its relationships with consumers, employees, suppliers, and partners with a digital-first mindset or risk being disrupted by digitally native competitors. Nearly every company now needs to become a software and digital experience company.
To capitalize on these trends, we seek to identify the leading disruptors and enabling technologies that have robust, long-term opportunities for sustainable growth as well as strong competitive moats that will enable them to capture that opportunity.
NK: Our research analysts have consistently found the strongest revenue and earnings growth potential among companies with technology at the core of their business strategy. Today, our portfolios are benefiting from a number of related secular trends that we believe are in the early stages of their evolution. These include:
Our specialized research analysts establish contact with emerging players early in their development, in order to ensure we stay up to date with the competitive landscape, but also to identify potential future opportunities for our portfolios.
Legal Notices & Disclosures
The views expressed herein are those of Harbor Capital Advisors, Inc., Sands Capital Management, LLC, NZS Capital, LLC, and Jennison Associates, LLC investment professionals at the time the comments were made. They may not be reflective of their current opinions, are subject to change without prior notice, and should not be considered investment advice.
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Harbor Capital Advisors, Inc.