US technology stocks had another standout year in 2020. The COVID-19 pandemic hastened a digital transformation trend that has shown no signs of slowing down. Franklin Equity Group’s Jonathan Curtis explains why he believes the pandemic marked the beginning of many companies’ digital journeys. He also shares his thoughts on what might be ahead for the sector, once a vaccine is distributed, and what issues he’s watching as a new US administration takes the reins in January.
As we exit 2020, it’s clear that technology has accelerated its role in everyday life. The coronavirus has driven people to rely on technology for working from home, educating from home, e-commerce, remote health care, contactless delivery and other uses. These technologies have become dramatically more pervasive for many of us over the past year.
This accelerated adoption of technology-related themes has led many companies in the information technology (IT) sector to be standout performers for most of 2020. The sector has also offered the best growth profile in the S&P 500 Index over the past four years.
A Look at Tech Valuations
Investors have asked if tech companies’ valuations are justified. According to our research, the IT sector has traded at an average 13% premium to the S&P 500 Index over the past 30 years, as measured by price-to-earnings ratios on a 12-month forward-looking basis. As of November 30, the sector is trading at roughly a 9% premium, which we believe is appropriate given the superior growth and quality in the sector.
Tech valuations may appear elevated, but as long-term investors we believe this modest premium is warranted and sustainable. We believe the coronavirus crisis has driven a long-term, structural acceleration of digital transformation (DT) and improved quality of businesses in the sector. We have also seen new investors continue to enter the sector for the structural growth and the relatively stable earnings profile versus other areas of the market. According to our analysis, information technology names look more reasonably valued when this growth profile is taken into account, and the sector has a price/earnings to growth (PEG) ratio that is generally better than the broader market.
Why Digital Transformation Is Just Getting Started
We believe digital transformation (DT) will have a long-term positive impact on the broader market and that DT will only accelerate from here. Companies that have embraced DT and continue to use DT as a key enabler of their businesses should deliver greater performance over the long run. We do not see this changing as DT and its associated sub-themes continue to gain relevance in a post-pandemic world.
Our research shows that DT is a massive, multi-trillion-dollar, multi-year opportunity still in its early stages. DT helps companies use software and data to understand their customers and business processes better. DT is also helping companies use technology to radically transform how their industries operate, and potentially disrupt existing players.
For many companies, the pandemic was the beginning of their digital journeys. Firms that had already been building out their digital capabilities leaned into those capabilities, and those that had neglected digital options were forced to quickly pivot. We believe that companies now need to operationalise what they learned during the crisis, scale what worked, abandon what did not work and continue to iterate and improve these processes.
What a COVID-19 Vaccine Means for Tech
News of promising COVID-19 vaccines and a possible end to the pandemic has raised questions about if non-IT companies are now offering more attractive valuations on a relative basis than IT sector companies. We believe that short-term investors may rotate out of technology and into other sectors positioned to benefit on the return to some semblance of normalcy as the vaccines are deployed.
We believe, however, that the secular always beats cyclical and that it would be short-sighted for long-term investors to exit the tech space. Companies, students, consumers and patients have built significant new digital skills and expectations during the crisis. They have learned how to uses these technologies and found them to be additive to their lives and their bottom lines. The productivity gains from these digital solutions are simply too compelling to abandon. We believe COVID-19 has permanently changed things for the better in the technology sector.
Risks to our Outlook
Despite our overall optimistic long-term outlook on technology, there are undoubtedly questions about how the power transition in Washington, as a new US administration prepares to take the reins in late January, will affect the technology space. We are paying particularly close attention to key questions of technology regulation and the US-China relationship.
On tech regulation, we will need to wait until it is clear which political party will control the US Senate. We believe, however, that the likelihood of a split government is greater than a government with single-party control. In the event of a split government, we think the large tech companies likely have little to fear as it will be difficult to find alignment across political parties on important business regulation topics. In the event of single-party control, we think the regulatory risk for tech giants increases, but also see significant legal hurdles for meaningful change. Furthermore, President-elect Biden has not signaled a great desire for regulatory change in the IT sector or the tech-adjacent communication services sector, beyond perhaps an in-depth review of Section 230 of the Communications Decency Act, which provides legal protection for tech companies over content from third parties and users.
On China, while we expect a Biden administration to lead with a friendlier tone, we do not expect it to yield critical ground the Trump Administration has gained. As such, we believe that China will need to come to the negotiating table on intellectual property protections and access to the Chinese market for large US tech companies, which are largely banned from operating in China today.
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