As earnings season kicks off for Q3, the S&P 500 finds itself -5.2% YTD, with the NASDAQ off -0.6% and the Dow off -7.6%. In hindsight, the reasons are fairly clear – a slowdown in China, a collapse in oil and commodity prices, sustained dollar strength, interest rate uncertainty, and slow growth have all played a role in providing negative returns and volatility. Given this is a pre-election year, it’s uncommon to end it down. Optimists on the Street believe that the US consumer will come to the rescue in Q4 – but given the shaky jobs report for September, even that’s in question. Amid such times, does the technology sector deserve to be pulled down with the broader indexes? Here’s what we’re thinking this week:
Technology had a better Q3 than 7 out of its 9 peer groups, off only -3.7% compared to the S&P 500’s -6.4%. Today, it finds itself at a forward PE multiple of 14.4x, well under its 15-year average of 19.7x (JP Morgan data). Granted, trending with the market is natural for this sector, given that at 19.7%, it forms the largest component of the S&P 500 index; Apple, by itself, constitutes nearly 4% of the index’s capitalization. Also, it derives the maximum revenues out of any sector from overseas, and therefore is bound to suffer with a stronger domestic currency; the dollar index is up nearly 6% YTD. For long-term investors, however, stocks in the sector remain at enticing levels.
To describe the potential, let’s start with a macro perspective. GDP growth is composed of population growth and output growth. Over the next 35 years, the world’s population is set to grow to 9.7 billion from today’s 7.3 billion (UN Data). However, the working-age population growth is set to trail total growth – and given life expectancy is projected to continue its upward trend (today, it’s at nearly 70 globally compared to 50 about five decades ago), GDP trends are also forecasting lower. Per McKinsey, the next 50 years will deliver barely 2.5% in annual growth, compared to 3.8% in the previous 5 decades. As Ruchir Sharma stated in the WSJ recently, to achieve a 4% growth rate, output growth – or productivity – would have to contribute 3.5%, a ‘rate never achieved in the post-war era’ – to compensate for the working age population growth of just 0.5%.
This is where technology stands to disrupt. Think terms including Big Data, the Internet of Things, and the cloud – all are frontiers that currently roam in the regions of $10s of billions in revenue amid a handful of firms – but have a potential to transform practically every activity consumers and companies undertake. Given the slowdown in worker growth described above, along with the advent of emerging market firm competition, it’s inevitable that developed-region companies will turn to technology for the next push forward. McKinsey estimates that the digitization of the physical world has the potential to create an economic impact of $11.1 trillion within the next 10 years – today, standing alone, it would be the 2nd largest economy after the United States. Per McKinsey, barely a fraction of the existing data is currently utilized for real-time control by firms and individuals. And, according to a study by the HBR 3 years ago across 330 North American public firms, ‘companies in the top third of their industry in the use of data-driven decision making were, on average, 5% more productive and 6% more profitable than their competitors’. IDC, meanwhile, is forecasting worldwide cloud IT infrastructure to grow nearly 24% YoY in 2015. In a broader market where single digit positive returns are bringing sighs of relief from weary investors, such numbers are a breath of fresh air. In the short term, looking at sectors beyond technology, such as healthcare, estimates for Q3 show revenue growth for biotechnology to be around 18% and health care technology to be 40% (according to Factset) – again, enormous gains in the same slow S&P 500 marketplace. The key, again, is technology – and any industry embracing it is seeing notable growth. In the transportation sub-sector, meanwhile, UPS is now utilizing software through its Orion project, which stands to save nearly $50 million by reducing one mile off each of its driver’s daily routes by 2017. So, alongside revenue growth, there’s significant room for efficiency improvement and cost reduction – and the transformation is just getting started.
There’s enough evidence to suggest Silicon Valley – and some investors – are on to this. Phenomenal returns by companies such as Amazon, despite barely showing profits over long spans, are a key data point. At the same time, the word ‘some’ is emphasized – given that the potential remains significantly untapped. While the IoT, cloud and Big Data terms have been around for the past decade, the tech sector has returned roughly 260% since the March 2009 recession bottom – slightly higher than the S&P 500’s 220% return and nothing noteworthy; all of this while GDP has averaged 2.2% in the US economy. During the same span, companies such as Salesforce have transformed the ERP and CRM foundation, Apple’s relationships with IBM and Cisco are setting up to transform enterprise behavior, and firms such as Netflix and Facebook, meanwhile, are generating and using data like never before to track consumer habits. Alongside, the iWatch was introduced, Uber and AirBnB transformed asset utilization, PlanetLabs delivered images from shoe-box-size satellites to the masses by the second, and the largest, cheapest desalination plant was set up in Israel. Apple’s patent filing for a ring in 2014 was revealed this week – and given the potential for wearable technology, it’s just another sign that Silicon Valley’s thinking ahead – alongside making the case for equity investment.
To add to the benefits, the technology revolution also stands to positively impact the labor market in the long term. According to Gartner and IBM, data analytics job positions will reach over 4.4 million by the end of this year, but only 33% of them will actually be filled due to the lack of qualified job seekers.
What it means for you: Wall Street remains focused on subjects including interest rate projections, quarterly reports and China’s economic slowdown. The key for thinking long term, however, is to look beyond these topics. It’s inevitable that China will move towards a consumption-driven economy. Interest rates will rise at some point, and the markets will adjust accordingly. However, as a participant at the Dreamforce conference a few weeks ago mentioned, the visionaries on the stage weren’t thinking about rate hikes. They were purely focused on innovation and opportunities in the long term. Can it be a coincidence that stock markets have also, without any argument, delivered for those that have chosen to stay invested for the long haul? We don’t think so. At a time when volatility continues to captivate investors’ minds and the bulls and bears battle it out, look beyond the short-term chaos for long-term opportunities arising from technology, which is set to pave the path on Wall Street in the years ahead.
