Have we been here already?

Discussing the long-lasting sell-off of the IT sector in the United States, market participants were looking up past examples to draw historical parallels in an attempt to make heads or tails of the current environment, but it is never just the same. As such, some experts were comparing what has been happening since the beginning of 2022 to that of the early 2000’s (known as the dot-com bust), mostly due to the similarity of excessive valuations, rising interest rates and bubbles in multiple asset classes, like real estate or private equity.

The bubble of 2000’s was triggered by low key rate environment (1998-1999) that facilitated oversupply of cheap capital to emerging internet companies, but as soon as the funding dried up, many of these businesses collapsed, taking the entire market along with them. Between 1995 and 2000 peak, the Nasdaq Composite index rose 400%, only to fall back 78% by October 2002.

This time, valuations were also overstretched, near-zero interest rate setting was also present, while Federal Reserve supplied the market with record liquidity. On top of that, pandemic sped up technological shift, allowing tech stocks to thrive and conquer, which transferred into significant share price gains. Then, a 150 bps hike in the policy rate has sent both, the market and the Technology sector, into a downward spiral in the first half of 2022, with tech-heavy Nasqaq Composite losing 29.2% in Total Return.

Figure 1: Nasdaq Composite index performance – 1 year before and after peaks (February 20 00 and December 2021)

Can it be that the rebound from March 2020 lows that happened too fast and stretched up too far has, indeed, created a similar bubble to that of 2000’s? We take a closer look from the corporate perspective and compare the current and historical state of the Technology sector, as well as attempt to see if it has become better positioned to help carry the markets across most possible scenarios.

Or has the IT sector upgraded from two decades ago?

During the dot-com bubble, S&P 500 Information Technology sector has seen a drastic deterioration in profitability, with sectors’ Return on Equity (ROE) collapsing almost two-fold (from 22% in 1999 to just 12% in 2002), although margins showed somewhat better resilience.

Figure 2: Selected Quality characteristics of the S&P 500’s Information Technology sector (as per month of July)

Source: Hérens Quality AM, Reuters

At the same time, sector valuations have reached their peaks in 2000, but if one looks at Forward PE (which is a function of current price to consensus EPS estimate), it clearly shows that striking appreciation in IT valuations was unjustified given modest growth expected of the sector in the nearest future and, hence, had to be inevitably corrected.

One of the main reasons for the early 2000s tech sell-off was that non-profitable, hardware-heavy, internet companies emerged too early for their time, making the shares initially soar on pure expectations and subsequently collapse as environment deteriorated and reality-soaked in. Two of appropriate examples would include Garden.com, which cut 40% of its workforce a year after the IPO and was forced to close after 14 months. Or the Webvan grocery delivery service that, at its peak, had reached a market cap of $1.2 bn right after the IPO, only to become one of the largest failures of that era as the company disappointed investors by not meeting its own growth projections and went into shutdown by mid-2001 to be eventually acquired by Amazon.

If we transfer to present days, the picture is clearly different. While it has to be admitted that pandemic did provide a certain tailwind for the technology companies as necessity of working-from-home facilitated transition to hybrid working practices, it was just an additional source for growth that layered on the top of already existing secular drivers for expansion. Ongoing migration to cloud, expansion of Internet of Things, Artificial intelligence and Data Centers are just few to mention – they were there before the pandemic and still remain after the world moved on from Covid-19. One of the reasons behind such encouraging setting is ongoing investments in Research and Development in order to ensure sustainable future competitivness of the sector – with R&D to sales closing in to 13%, this is more than what tech companies back in 1999 were capable of. The sector has also moved from hardware into software, building significant share of more resilient recurring revenues.Therefore, unlike back in 2000’s, this is also reflected in forward valuation – with sector’s current PE of 38.6, it’s forward PE is as low as 25.3, which is a clear signal that market acknowledges substantial bottom line expansion ahead.

Moreover, from fundamental perspective, pandemic was not a major deal breaker for the sector in terms of returns. Indeed, sector’s ROE has improved in 2020 to 28%, but even as things got back to normal, indicator continues to sit well above 20 percent two years later. It is also true that in the present days, Technology companies were more willing to take advantage of low interest-rate environment and accumulate debt to, among other things, pursue value adding acquisitions. However, that did not materially impact their balance sheet strength, as equity ratio for the entire sector remains in a healthy 40%+ range.

Attractively Valued Quality IT is even more resilient

If we look specifically at attractively valued quality IT – the group commands significantly higher profitability and returns, holds essentially no net debt relative to equity and has more moderate valuation ratios (trailing PE) than the broader sector of the S&P. Besides, companies are well financed and hold sufficient resources to keep iterating on new products & services to remain relevant. Therefore, we believe that high-quality tech leaders can weather ongoing macro headwinds much better than the broader market and respective sector.

Figure 3: Selected characteristics as of 31.07.2022 (Median method)

Source: Hérens Quality AM, Reuters

Sell-off experienced in the first half resembles more of a negative sentiment shift that is not supported by fundamentally healthy operating results, unlike during dot-com bust – when sector was full of new, highly unprofitable companies that vowed to “change the world”. Sector rotation that happened in July – with a strong rebound in IT – is a good argument in favor of this theory.