Tech sector holds promise in 2017

The tech sector is far from uniform. Mature businesses such as U.S.-based firms International Business Machines Corp., Intel Corp., Cisco Systems Inc. and Oracle Corp. trade below the sector’s market multiples, while companies such as Facebook Inc. and Alphabet Inc., both of which offer “significantly higher earnings growth potential,” trade above.

Facebook, which is trading at 22 to 23 times 2017 earnings, is rich in assets, such as Instagram and WhatsApp, both of which are not generating revenue as yet, but have longer-term potential, says Mark Lin, vice president, international equities with Toronto-based CIBC Asset Management Inc. and portfolio manager of CIBC Global Technology Fund. “Instagram has more than half a billion users,” he adds, “and WhatsApp and the Facebook Messenger apps have a billion users.”

Obvious growth areas in tech revolve around e-commerce, digital advertising, marketing and social media networks. Many firms are U.S.-based – Lin, for example, points to Seattle-based Amazon.com Inc. for its e-commerce and cloud-computing businesses – but there are international alternatives.

“The next destination would probably be Asia, and this is where [investing] gets interesting,” says Kurt Reiman, chief investment strategist with Toronto-based BlackRock Asset Management Canada Ltd. Tech now represents 25% of emerging markets’ stock-market capitalization, he says, making [those regions] a promising destination for clients wanting to bulk up on tech stocks.

Cases in point, China-based online marketplace Alibaba Group Holding Ltd. often is called the “Amazon of China.” The stock is trading at around its 2014 initial public offering’s level. China-based search giant Baidu Inc., effectively China’s Google, saw a drop in both revenue and profits in the third quarter as a result of the firm’s unprofitable but rapidly growing streaming video service. The fast-growing number of Internet users – and online shoppers – in China represents promise for these stocks.

Although Reiman won’t discuss specific stocks, China-based tech conglomerate Tencent Holdings Ltd. was the third-largest holding in BlackRock World Technology Fund at the time of writing. Tencent stock is also the fourth-largest holding in Lin’s CIBC fund.

“[Tencent’s video] gaming business is very profitable, with a big population to serve,” Lin says. In addition, the firm’s WeChat social messaging platform includes e-commerce capabilities and has 850 million active subscribers. “These kinds of markets tend to be ‘winner take all’ markets due to the loyalty of users whose friends are all connected to the same service,” he adds.

U.S.-based Activision Blizzard Inc. is another hot video-gaming pick, according to Jordan McNamee, an analyst with Cambridge Global Asset Management, a division of Toronto-based CI Investments Inc. Activision, which is responsible for high-quality gaming franchises such as World of Warcraft and Call of Duty, is set on monetizing its customer base by offering more in-game purchases, he says. Furthermore, the company’s acquisition of Ireland-based large mobile gaming firm King Digital Entertainment PLC will help.

“[Activision is] currently trading at 13 times 2018 cash earnings,” McNamee says. “We see significant value with a tremendous amount of optionality from the creation of a large and meaningful e-sports and media business.”

Japan-based telecommunications and Internet firm SoftBank Group Corp. also is poised to take advantage of the growth of mobile technology, having bought U.K.-based semiconductor firm ARM Holdings for US$31.7 billion as part of a push into the “Internet of Things” (IoT) and mobile devices. SoftBank, which also owns U.S.-based telecom firm Sprint Corp., recently pledged to invest US$50 billion in its broad U.S. operations. SoftBank recently acquired a large stake in Channel Islands-based satellite Internet startup OneWeb LLC for US$1.2 billion. SoftBank also is raising a US$100-billion investment fund in partnership with Saudi Arabia’s public investment fund. Areas of interest for the SoftBank/Saudi fund include robotics, IoT and artificial intelligence (AI).

“AI [will] be the biggest thing you’ve seen in computing technology in the past 10 years,” says Mark Schmehl, portfolio manager with Toronto-based Fidelity Investments Canada ULC, who manages Fidelity Canadian Growth Company Fund and Fidelity Special Situations Fund.

AI’s gravitational field is pulling in companies from across the software and hardware sectors. Germany-based SAP SE, a business software firm and rival of U.S.-based Oracle Corp., announced last year that machine learning (a type of AI) will be a focal point in the future. SAP’s third-quarter operating profit was 1.1 billion euros (down by 9% year-over-year) on revenue of 4.37 billion euros (up by 8% year-over-year).

AI, along with other growth technologies such as video gaming and virtual reality, will rely on semiconductors. The semiconductor industry typically is frowned upon because of strong competition and rapid obsolescence, says Schmehl, but that’s changing, thanks to industry consolidation and a growing demand shock from AI and related technology.

“The AI wave is an entirely different computing platform,” Schmehl says. Graphical processing units (GPUs) excel at floating-point mathematics – also used in AI – so expect GPUs in hardware from virtual-reality headsets to self-driving cars – both products foreseen as growth industries for the next decade.

Schmehl highlights U.S.-based Advanced Micro Devices Inc. (AMD), whose valuation trails that of U.S.-based market leader Nvidia Corp., which announced a partnership with Baidu in 2016 to develop self-driving cars.

“Every time there’s a cycle, you want to own the lesser players because they go up way more than the good guys,” Schmehl says, “and AMD is the lesser player.”

AMD’s stock price increased almost threefold in the past year, spiking upward by 30% this past November after the firm announced that its GPUs would be used in Google Inc.’s data centres. AMD also supplies chips for Japan-based electronics giant Sony Corp.’s PlayStation, which now has a virtual-reality component.

Non-GPUs still are needed for an array of other devices, including smartphones and tablets. Taiwan-based Taiwan Semiconductor Manufacturing Co. Ltd. (TSSC) makes the Top 10 list of holdings in Lin’s CIBC fund, with 60% of TSSC’s revenue derived from components for telecom devices, including Apple Inc.’s iPhone and iPad devices, for which TSSC won the exclusive contract last summer. TSSC edged out South Korea-based rival Samsung Electronics Co. Ltd., the largest maker of memory chips. (SK Hynix Inc., also of South Korea, is investing $1.8 billion in a new microchip fabrication plant.)

McNamee also likes U.S.-based semiconductor conglomerate Broadcom Corp. because it has moved away from these markets. Broadcom has grown its earnings per share at a 42% compound annual growth rate partly through acquisitions made over the past four years. The company’s stock trades at around 12 times 2018 cash earnings and its 2.4% dividend yield will rise, he adds.

“[Broadcom] changed the composition of its revenue from 50% exposed to smartphones, for which volatility is high due to short product life cycles,” McNamee says, “to now having more than 65% of its revenue focused on networking and storage, for which revenue is higher-quality and more stable.”

One of the wild cards in the tech sector is the approach U.S. President Donald Trump’s administration will take in certain key areas. One upside could be the repatriation of offshore earnings, Reiman says, which would enable tech firms to return more value to shareholders.

“On the negative side,” McNamee says, “any change in the ability to trade overseas could have negative implications for all hardware companies that manufacture overseas.” Rumblings about penalizing imports also is worrisome for firms that import components.

Removing interest deductibility, McNamee adds, would reduce the benefit of debt issuance to repurchase stock, which has been a growing trend among cash-rich tech firms. Such uncertainty might be a good motivator to balance U.S. tech stocks with those in other regions.

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