Is tech the only game in town?

With the surge in working-from-home and desire to do most activities online since the outbreak of COVID-19, technology shares have outperformed. Tech valuations have hit new highs and, according to some investors’ surveys, demand is so strong that their ownership has reached “crowded” levels.

The attributes exhibited by most technology companies appear attractive. But rather than being fixated on technology, we believe that investors can find similar exposure in other sectors.

What is a technology stock?

While the term “tech stocks” is widely used, it can also be misused. There appears to be some confusion as to what a technology company really is. This was compounded by the re-shuffling of the official sectors classification by some of the largest index providers in 2018. At that time, tech companies were scattered around various industry groups spanning from consumer discretionary (say e-commerce) to communications services (social media).

As a result, today only two of the infamous Facebook, Apple, Amazon, Netflix and Google parent Alphabet (known as FAANG) stocks are officially technology companies. In this context, referring to the tech stocks and their outperformance versus the rest of the market seems incorrect. Instead, the divergence seems to be between the “old” and the “new” economies.

Using this framework helps us better understand why many of the so-called technology companies have been able to deliver outsized returns over the past decade. Indeed, whether they belong to the tech sector or a different category, companies offering solutions to the new economy tend to exhibit a combination of:

a) growth rates well in excess of economic growth
b) asset-light and recurring-business models and
c) strong balance sheets.

Dissecting the appeal

Investors have always been drawn to companies offering attractive growth prospects. In the sixties and early seventies, the “Nifty Fifty” became the US stock market’s darlings thanks to their seemingly unparalleled prospects. Many of these companies belonged to the staples sector as, at that time, this is where strong growth was while today technology can play a large part in driving expansion.

The other key attribute of most tech companies is their asset-light and recurring-business models. In the new economy, companies tend to operate “platforms” and sell subscription-based services (instead of manufacturing products sold in one-off transactions). This approach often allows them to generate a higher return of equity and stronger free cash flow than “old economy” peers. In a world of low discount and hurdle rates, the demand for assets with such prospects can allow them to command a higher valuation.

Finally, being highly cash generative, most tech groups can finance their operations and expansion without needing to assume much debt. As a result, their balance sheets tend to be stronger than peers, reassuring investors in turbulent times and allowing M&A activity to bolster growth. In other words, the “over dominance of large tech”, does not seem to be a reflection of investors’ exuberance. Instead, the financial success of these companies likely reflects business models that are geared towards the 21st century and poised to succeed in the current environment.

FAANGs can bite

One area of concern is the rather limited breadth of new economy companies that investors tend to own in their portfolios. Indeed, most investors’ interest appears to be gravitating around a handful of high-profile stocks (especially the FAANGs). As attractive as their growth prospects may be, such a narrow concentration may expose investors to idiosyncratic risks, chief among them seemingly being increased regulation.

For this reason, instead of blindly pursuing exposure to technology stocks, investors should focus on companies that share similar qualitative attributes (such as a high return on capital, high growth and low leverage) but belong to other sectors. With disruptors targeting almost every industry, opportunities to own a diversified mix of tech-like stocks are plentiful.

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