The Role of Technology

Delwin Graham - Jan 29, 2020
The tech sector is fast-paced and hyper-competitive, and it is notable for its rapid obsolescence cycles.

The past year has been a particularly good one for investors. In 2019, the US markets as represented by the S&P 500 were up approximately 30.4% while the Canadian TSX/S&P 60 was up about 18.9%. This growth was led in the US by the information technology sector of the S&P 500, which rose approximately 47.5% over the year. Technology is the largest single segment of the US market, eclipsing all others (including the financial and industrial sectors). It has expanded far beyond what we might consider to be typical tech stocks like Apple (AAPL: NASDAQ), Microsoft (MSFT: NASDAQ), and IBM (IBM: NYSE). In fact, these companies operate across several key sectors of the technology market: software, hardware, semi‑conductors, and networking. (Cf., Stephen Simpson, “A Primer in Investing in the Tech Industry”, www.investopedia.com, May 26, 2019)

The tech sector is fast-paced and hyper-competitive, and it is notable for its rapid obsolescence cycles. For example, software requires virtually no infrastructure and is difficult to protect via patents or copyright. As a result, companies and new products can scale up very quickly. Video gaming companies like Electronic Arts (EA: NASDAQ) and Activision Blizzard (ATVI: NASDAQ) are good examples of this explosive growth. “Cloud computing” has further amplified the opportunity in this sector because it allows several companies to offer software as an on-demand application (typically through the internet or a closed network) as opposed to code residing on an individual customer’s hardware. Amazon (AMZN: NASDAQ), Alphabet (GOOGL: NASDAQ), IBM, and Microsoft are all major cloud players. (Cf., Daniel Kline, “Everything You Need to Know About Investing in Technology”, www.fool.com, Sept 20, 2019)

But “software as a service” (SaaS) still requires hardware, in order to run its instructions. While not as topical as it was a few decades ago, the hardware sector is still a key component of the technology industry. Computers have evolved into a vast array of devices from self-driving cars, as currently being developed by Tesla (TSLA: NASDAQ) and other companies, to mobile devices that can essentially replicate and replace many of the functions of the personal computer – we call them “smartphones”. Other new products, like virtual-reality headsets and “wearables”, can revolutionize consumer hardware. Companies that produce personal devices include Roku (ROKU: NASDAQ), Fitbit, and GoPro. Furthermore, the continuous consumer demand for information technology fuels ongoing innovation in routers, servers, and data-storage devices. Companies like Cisco (CSCO: NASDAQ) and Intel (INTC: NASDAQ) provide this backbone equipment.

Semi-conductors underlie virtually everything else in the technology sector. Because they are so ubiquitous, semi-conductors sell like a commodity and often follow a boom-bust cycle. What matters most for companies is the ability to design superior products (more features per chip, less power consumption, more reliability) at the best price. The semi-conductor industry is led by companies like Applied Materials (AMAT: NASDAQ), Intel, and Nvidia (NVDA: NASDAQ).

Networking is in many respects a sub-sector of the other three sectors; it requires hardware (which requires chips) and software to function. But the opportunity supplied by networks is enormous. The internet itself, which is one vast network, has facilitated major changes to commerce and has underpinned new business models like ride‑sharing, mobile banking, and software as a service (SaaS). Most companies like Alphabet’s Google, Microsoft’s Bing and MSN, Twitter (TWTR: NASDAQ), and Verizon’s Yahoo (VZ: NASDAQ) are supported by advertising revenue but also monetize in other ways.

Whereas technology companies are associated with innovation and invention, they are expected to spend a considerable amount on research and development. Tech stocks frequently sport higher premiums than any other market sector. The theory is that the high level of valuation is in recognition of the above-average growth rates that successful technology companies can experience. But there is also a large number of public tech companies that do not produce profits or cash flow at all. As a result, investment in the tech sector always takes place within a tension between optimism and skepticism.

For example, John Colley argued in early 2019 that the current “app” boom was similar to the dot-com bubble that burst in 2000 (Cf., John Colley, “Why 2019 Could Be the Year of Another Tech Bubble Crash”, www.theconversation.com, January 11, 2019). At that time, investment banks were encouraging enormous investment in dot-com ventures by launching Initial Public Offers (IPOs) and allowing early investors and executives to cash out their private shares. The cash burn was meant to build a brand and create network effects – that is, to make something more valuable by increasing its use. But most of the dot-coms that listed on stock exchanges had done little more than consume vast amounts of investors’ cash and showed little prospect of achieving a profit. Traditional metrics of performance were overlooked, and big spending was seen as a sign of rapid progress. Colley sees a similar fate for ride-sharing apps like Uber and Lyft, as well as the social media app Snapchat. He argues that it is only a matter of time before the app bubble bursts.

Granted that, prudence is always advisable. Companies in the tech sector are always subject to “irrational exuberance” because of their potential for scale. But that does not preclude the possibility that some will actually scale up – consider Facebook (FB: NASDAQ), Google, and Amazon. As investors in the tech sector, we must be aware of the opportunities that develop and dissolve. Of course, some investors will want to avoid the vagaries and volatility of the sector as a whole and steer clear. But technology is one of the most dynamic and powerful engines of economic growth. There is no sector of the modern economy that does not rely on technology to make things faster, cheaper, and more convenient. And so, as an investor, you ignore the tech sector at your own peril. Consider its effects on the photography, taxi, energy, and hotel industries. There is no safe harbour. For a few interesting trends in tech, please contact me at dgraham@cgf.com or 780-408-1518.