As technology names correct globally, investors are concerned about their holdings in the space. Morningstar US Technology saw 17% of stocks correct over 50% from a 52-week high. For the Morningstar US Communication Services index, that number is 22%.
But do you really have to worry about your tech stock? We don’t think so. In fact, there may be some attractive opportunities in the space. Editors Ruth Saldanha and Ole Smith met with Morningstar CTO Brian Colello to ask for his views on the current situation. This is an edited excerpt from that conversation.
Olly Smith: The massive trend in tech stocks has been on top of our minds since the beginning of this week, but when did it really start?
Brian Colello: Software stocks definitely fell at the start of 2022. There are several reasons for that. First, we saw the US Federal Reserve signal tapering, an eventual reduction in bond purchases. In addition, the inflation rate in the United States (and the world) has also risen. All this points to higher long-term interest rates. In technology, and especially in software, much of the profits of these companies will be generated in the future. So we are now in a world where we have higher interest rates, which leads to a higher discount rate, which increases the likelihood that investors will place less value on future earnings than they would have in a very low interest rate environment. And so we see the sale of software stock.
Ruth Seldanha: Some of these stocks are much lower than they were last year – 17% of stocks in the Morningstar US Technology index are more than 50% below their 52-week highs, and that number rises to 22% from the Morningstar US Communication Services index. Why are these stocks dropping so much, and should investors be concerned?
Colillo: It’s a good question. We would argue that Zoom Video Communications (ZM) as an example, should not have been a $700 stock, so this pullback is justified.
Our fair value estimate for Zoom has risen over the past two years, because the company has experienced significant growth during the coronavirus downturn. But in many cases, we believe that investors are outpacing high-growth stocks. You can attribute this to two factors – One could be very low interest rates, and the other very high liquidity.
Investors looked at the Fed’s views on stimulus and money printing, for example, and considered the future of remote work, and that’s where they put their money during the pandemic. Now I wish we had some light at the end of the tunnel. We go back to offices more often, and it kind of normalizes, and the trend of investors hoarding remote working tools seems to be waning from our perspective.
These names are still uncertain because Covid-19 is difficult to predict. So we have very high fair value uncertainty ratings on these names. Having said that, we also believe that investors have oversold some of these stocks. We see opportunities in names like Zoom, DocuSign (DOCU), and Zendesk (ZEN), where the sell-off has been pretty intense. DocuSign is probably our favorite among these three because it has a unique business model.
Saldanha: Some investors are wondering if this is a good entry point for the sector, or if it’s time to start taking profits. What is your opinion?
Colillo: I can’t comment on whether investors should exit; This is up to each investor’s risk profile. In a scenario with a lot of uncertainty, we’ll focus on high-quality names. There are a lot of people in our coverage world who have done very well in 2020 and 2021, and in that downturn, some of these names are cheap now. We are likely to direct investors to a broad economic moat and high-quality software names that have been beaten up as part of this sale. Salesforce.com (CRM) and Adobe (ADBE) are two notable features of our software coverage. Broad ditch names have very sticky customers, high quality business, average fair value uncertainty, and haven’t sold as much as high quality flyers
Smith: Given the uncertainty surrounding Covid-19, to what extent do companies really control their own destinies? Some would say there has never been a worse time to plan, in the manner of speaking.
Colillo: This is a reasonable assessment. Software is a very sticky business. Software companies with wide or narrow economic moats earn it based on customer switching costs. Look at it this way: the software takes time to implement, there is a steep learning curve (because there is very important data or processes within a company being transferred to that software), and the software seat is eliminated or removed to try and go to a cheaper alternative that takes a great deal of work – And perhaps most importantly, stop working – Companies hate doing this. Even at the start of the pandemic, when we moved to remote work, we thought companies were unlikely to cancel or scale back their Salesforce or Adobe subscriptions. So far, companies continue to maintain, if not expand, these programs, as companies focus more on digital transformations.
Companies obviously can’t control the coronavirus, but software has been one area where the product works, whether we’re all in the office or working from home. Even in early 2020 to mid-2020, we were writing that the software was an area of relative security, and high-quality broad trench software names such as Microsoft (MSFT), Salesforce, and Adobe were procured. And it worked, because no company ever canceled those contracts, and instead these companies continue to grow as companies rely more and more on software.
So, to the extent that companies control their own software, they can control their own destiny, probably better than a lot of other industries for sure. Once you install the software with the company it becomes very sticky. What can be discussed, and what could lead to fluctuations in the stock price, is how much space the business has to grow in the next five to ten or fifteen years, what the world looks like at that point, and Watt’s competition like.
This is where we have the greatest uncertainty. But we don’t have a lot of uncertainty about how these companies deal with existing customers – they stick to the business, they keep most of their customers, and more often than not they sell what they sold in the previous year. We really like looking at group analysis, where. Suppose a company sells $1,000 worth of software to a customer in the first year, and we might see that the company sells $2,000 worth of software in the second year, and $3,000 in the third year. High contract values with each client each year are a good sign that the program is consistent and that companies value it.