Fundamentals underpinning global tech’s market leadership

As we enter the new year, we find the technology sector in the unique position of being both a dominant force in financial markets and one whose transformative potential is still misunderstood by many investors. Lost in the “here and now” of the Magnificent Seven’s (Mag 7) massive share of global market capitalization and the steady buzz surrounding artificial intelligence (AI) is the degree to which this nascent technology – along with other secular tech themes – will reshape the global economy.

As companies deploy AI applications to boost productivity and households increasingly rely upon them to accomplish daily tasks, the most innovative and forward-looking constituents of the tech sector, in our view, will increase their share of aggregate global earnings.

Laying the foundation

Proof points for this thesis are starting to appear. Consequently, the uniformity of returns for companies even loosely associated with the AI theme are starting to break down. Investors are now gaining visibility into which companies are taking the lead in bringing about this revolution or effectively integrating AI into their business models.

Within semiconductors and other segments responsible for creating the infrastructure necessary for AI to reach its full potential, we are seeing a narrow set of winners emerge. Included in this set are sophisticated producers of graphic processing units (GPUs), the factories – or fabs – that build them, and makers of the capital equipment needed to pull off such engineering feats.

Fortifying business models

Software has long been recognized as an important mechanism for delivering AI’s efficiencies. Only now are we beginning to see which software companies are most effective at complementing their core offerings with AI. This development is one reason behind improving near- to mid-term prospects for software. Another is better fundamentals after a stretch of lacklustre performance.

Also providing a tailwind for software is the expectation that a deregulatory agenda in the U.S. could translate into an extension of the economic cycle, thus firming up demand for more cyclically sensitive products. And given that much of the software complex is North America-centric, it should be largely immune to the risk posed by rising trade barriers.

The internet is another space where companies have aggressively sought ways to leverage AI to improve their competitive positions. This is particularly evident in the midcap segment, where distinct leaders are emerging in verticals ranging from travel and e-commerce to food delivery and music. Furthermore, their leadership could prove durable due to a combination of superior intellectual property and a possibly more rigid regulatory framework freezing the current industry structure.

The upshot across the semiconductor, software, and internet spaces is a dispersion of returns between perceived AI winners and laggards. Dispersion is also occurring within the Mag 7 as idiosyncratic forces drive stock performance. Far from just an AI story, these companies are once again being assessed on their operational execution, ability to effectively allocate capital, and exposure to potential shifts in the regulatory environment.

An eye – still – toward Washington

The conclusion of the U.S. election cycle hasn’t ended regulatory uncertainty, as tech-sector oversight was a prominent feature in both presidential campaigns. We expect certain export controls that were initiated under the first Trump term – and continued under Biden’s – will remain, if not become more restrictive. Squarely in the crosshairs are inputs necessary for advanced applications, including the most complex GPUs and semi capital equipment.

In other segments, tariffs have the potential to stifle innovation and create duplicative supply chains. As evidenced by China’s scaling of its analog chip capacity, such a development would likely result in a step back from the recent discipline within the semiconductor industry.

Internet companies will likely continue to face questions about their size and reach. While the incoming administration may champion some market-friendly policies, we believe that many companies will approach expansion, including into adjacent markets, with caution. Although that may hamper the outlook for acquisitions, a potential bias toward “little tech” may result in an improved environment for taking companies public.

To be determined is whether punitive remedies suggested by the Biden Department of Justice toward large internet platforms would be softened under the Trump administration.

Getting what you pay for

A popular misconception is that tech’s market leadership has been fuelled by outrageous valuations. That’s not the case. In fact, relative to their expected earnings profile, many leading companies within software, semis, and the internet space trade at attractive valuations relative to the broader market.

We believe that an innovative theme’s impact on earnings is overestimated over the near term, but often underestimated over a five- to 10-year horizon. In this respect, selloffs driven by perceived valuation concerns can be viewed as opportunities to gain access to powerful secular themes capable of compounding earnings growth at an attractive entry point.

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