Navigating the Tech Sector: High valuations with higher potential? 

Market exuberance resulting from the advent of generative artificial intelligence (GenAI) has pushed tech stocks to astronomical valuations. The “Magnificent Seven” – Apple, Microsoft, NVIDIA, Amazon, Alphabet, Tesla, and Meta – accounting for about 28% of the S&P500, have been propelling US equities with a staggering average year-to-date return of 104% as of September 20, 2023.

This has led to concerns about concentration risk and overblown valuations becoming a focal point in the markets. Interestingly, some global investment managers believe that there is more value to gain from the seemingly expensive tech sector.

Keep on reading to learn if investing in tech stocks is worth it.

Macro headwinds remain but investors undeterred

Despite macroeconomic headwinds, global investors continue to maintain their stakes in the tech sector, buoyed by resilient earnings resulting from cost-cutting and rationalization measures. The market is also factoring in the potential impact of innovative offerings such as Microsoft’s Co-Pilot, an AI-powered tool designed to significantly enhance work efficiency.

Furthermore, global fund managers think it prudent to increase exposure to tech since AI is still in its nascent stages. As AI evolves, different sub-sectors are expected to experience growth in waves. For instance, NVIDIA has been seeing record sales in their chips given the current focus on building hardware capabilities. In contrast, once the building phase is complete, the next opportunity should come from companies that are utilizing AI in the most effective and innovative way possible.

Before looking far ahead, the current theme remains centered on macroeconomic factors. While there is currently still an elevated interest rate environment, tech firms are expected to see accelerated growth once the US Federal Reserve starts easing rates.

Fundamentally, once rates go down, these tech companies can start aggressively funding their growth. Unlike crypto that lacks utility, AI has a strong value proposition for corporates through improved productivity, as GenAI can act and produce output like a human.

Transformative value creation, from enablers to beneficiaries

In the midst of the ongoing transformation across industries driven by the adoption of new AI technologies, the question arises as to where true value creation will emerge from these innovative approaches. While value creation is a broad concept, it predominantly hinges on two main categories: enablers and beneficiaries.

Enablers can be seen as the companies facilitating AI’s performance, whether through cloud computing services, electronic design automation, software solutions, or other significant domains. However, not all enablers can be considered beneficiaries of AI, as it is far from a one-size-fits-all paradigm.

Called “winners,” these beneficiaries are the ones who can effectively leverage AI to enhance productivity. Given that it demands time, strategic planning, and substantial groundwork to train AI models with company-specific data, value creation primarily emanates from these AI beneficiaries.

The question now is: Which sort of companies have strong monetization potential, i.e., enablers? Currently, companies with the best data have the best fighting chance of improved revenue. AI models need training by supplying high-quality data, and companies like RELX, formerly Reed Elsevier, an information and analytics company with a stash of valuable data and reports, stand to benefit.

Going forward, AI models should become more intelligent, engaging in a more “human-like” manner. At this stage, investing should move from just data-rich companies to firms with secure and easy-to-use software that could be integrated into companies.

This, however, is not going to happen overnight as the cost of creating proprietary AI remains high, i.e. incumbents should shell out capital and transition from legacy data facilities to a more agile vendor. When this stage is completed, the company can transition from being mere enablers to becoming successful beneficiaries.

Sectors at play

After profound shifts and product-market-fit are at play, it is now time for companies to start adopting AI faster, rather than risk becoming obsolete. Companies should reimagine their workflow and start integrating AI into improving processes, allowing it to handle non-judgmental and process-oriented tasks.

For instance, if companies could hire fewer workers and offer better products or services in a more efficient manner, then they could improve profitability and see these benefits priced into their stock valuations.

On a sector rotation standpoint, healthcare stands to benefit the most as AI can assist in creating cures faster and diagnosing illnesses more accurately. We can look at it from a cybersecurity standpoint, too. As more companies rely on AI, this should translate into securing data, and cybersecurity firms are poised to benefit from this trend as they become increasingly critical in this quickly evolving landscape.

Quality over rapid growth

Diving deeper into company fundamentals, it is also crucial to understand the concept of quality. Quality, in this context, is determined by how “cash-rich” a company is, as minimal reliance on external funding is a testament to its potential for sustained growth.

Cash-rich tech firms who are able to fund their growth without relying on external funding have the best chance of outperforming in the long run. In evaluating opportunities within the tech sector, attention should be on prioritizing quality over rapid growth.

After assessing the long-term market prospects and competitive landscape of the industry, more targeted opportunities can be identified by recognizing high-quality positions within it. What truly makes a company appealing is its ability to self-fund and rely on its cash reserves, eliminating the need to seek additional capital from the market.

Sustainable long-term value creation through productivity

In conclusion, the global tech sector continues to thrive despite macroeconomic challenges. The advancement of AI presents promising opportunities as tech firms leverage its strong value proposition to enhance value creation.

For enablers, quality should top rapid growth; in contrast, beneficiaries that can reach the optimal level of productivity and integration through AI are poised to outperform their competitors.

Beyond profitability and quality, genuine value does not stem from mere investment in AI models by the major tech company – it lies within closely held companies boasting a finer approach on becoming more people-centric and client-oriented. Priority can then be shifted to further strengthen human connection, becoming more embedded in society at large.

ARIZ MARCELINO is a Research Officer at Metrobank Trust Banking Group with a focus on macroeconomic research and sector analysis to produce actionable investment insights. He has a degree in Banking and Finance from the New Era University which he earned while also working full-time. He has passed the CFA Level 1 exam and is also a Certified UITF Sales Person (CUSP). His principles in investing are greatly influenced by billionaire investor and hedge fund manager Ray Dalio and he is an avid fan of Mark Minervini, a super trader and best-selling author. When not at work, Ariz enjoys watching sitcoms like The Office and The Big Bang Theory while sipping a cup of hot matcha latte.

SOPHIA THERESE “PIA” BONIFACIO is a Research Officer at Metrobank Trust Banking Group, covering macroeconomic research and the consumer sector. She obtained her Bachelor’s degree in Economics with a Specialization in Financial Economics from the Ateneo de Manila University and is a Certified UITF Sales Person (CUSP). Outside of work, Pia spends her time with her best friend – a 9-year-old Chow Chow named Yao Ming.