Tech: Better days ahead

Stanislas Chanavat November 15, 2022 06:00

The technology sector may be out of favour right now, but we believe structural drivers remain strong and there are many investment opportunities to pursue, especially in private markets.

Valuations for technology companies have fallen steeply from their peaks, dragged down in a challenging macro-economic environment characterised by record high inflation, rising interest rates and slowing growth. As of end of September, the BVP Nasdaq Emerging Cloud index is down 51 per cent year-to-date while the NASDAQ has dropped 34 per cent. That compares with a 25 per cent fall in the S&P500, making tech one of the worst performing sectors globally this year.

So are technology's best days behind it? Far from it.

To begin with, private companies in the tech sector are nowhere near as weak or vulnerable as current valuation levels might suggest. On the back of record fundraising in 2021, they are very well capitalised, which means that mass bankruptcies, like those we saw in the early 2000s tech bust, should be avoided.

What is more, the median unicorn - private companies with valuations in excess of USD1 billion - now has USD108 million in annual revenues compared with just USD18 million for companies that went public during the dot-com bubble.1 In other words, today’s tech cohort is much more established, generating more revenue, and thus better prepared for what lies ahead. Tech firms' founding teams are also of higher calibre than was the case back then, with more and more repeat entrepreneurs coming back to market with exciting new ideas to pursue.

No less important are the fundamental trends supporting the private tech sector's growth.

The speed of innovation is accelerating. It has never been easier to start a tech company given all the tools freely accessible online. Cloud infrastructure, the backbone of the digital ecosystem, is growing at almost 50 per cent year-over-year. Internet use, meanwhile, will continue to expand. It is easy to forget that, despite its breakneck expansion, the web has yet to reach 31 per cent of the world population.2 Then there’s 5G: together with the Internet of Things, the next generation of wireless technology promises to take connectivity into uncharted territory.

Corporate IT spending should also remain robust. The consultancy Gartner predicts that businesses will spend an additional USD100 billion on software in 2023, bringing that market to USD900 billion annually. Cybersecurity will be another source of business investment. As the number and cost of cyber attacks has risen significantly in recent years, companies and governments have increased investment budgets for ever more sophisticated cybersecurity solutions.

Within retail, e-commerce will also continue to expand. Brands can access customers directly and in ways that were not possible just a few few years ago. The global eCommerce market is expected to reach USD5.55 trillion this year, representing a fifth of global retail. Amazon, the leading player in the industry, has now deployed more than 370,000 robots (up from 100,000 in 2017) in its warehouses as it delivers 1 million packages every two hours.

Crucially, there is plenty of capital available to support and encourage private tech companies to grow and innovate. In the US alone, VC firms are waiting to deploy more than USD290 billion.

For experienced investors in private markets, the tech sector presents attractive opportunities.
Of course, it is important to be selective. Now, arguably, more than ever. We expect to see increased differentiation between stronger and weaker companies. No doubt there will be some failures along the way. But also many success stories. We have seen iconic technology companies emerge from previous down cycles, and this time should be no different.
To identify the rising stars, we believe it’s important to focus on sustainable business models. Cheap capital is no longer available to fuel easy growth, which means companies need to work harder to deliver top-line results. As interest rates rise and investor preference shifts from growth to value, there is more of a focus on profitability and increased scrutiny on the potential to generate sustainable profits. Understanding a company’s unit economics, customer acquisition costs, gross margins, payback period and net retention rates is crucial.
High conviction sectors
Within the technology industry, we believe five segments look particularly promising:

• Enterprise software – Companies have a strong incentive to become more digital in order to streamline processes, reduce costs, futureproof their business models and, increasingly, attract employees. Software has a key part to play in this transformation.

• Fintech – From personal banking and investing to business accounts and international transactions, finance is becoming ever more hi-tech, and is no longer the preserve of a small group of large banks. New capacities brought by “software as a service”, or “banking as a service”, will completely redesign the value chains across financial services.

• Cyber security – Cybercrime is growing rapidly in complexity, in number of incidents and in terms of the scale of each attack. The risks have multiplied as more of us work from home using private devices as we do so. Cybersecurity is now a much bigger part of corporate IT budgets, and data privacy is also a key growth area.

• Consumer Internet – During the Covid-19 pandemic, people successfully moved their work, study, shopping, exercise and leisure activities online. We expect this trend to continue, particularly as the younger, tech-savvy generation grows up and commands increased consumer power.

• Industry 4.0 – Industry is embracing technology, from software to hardware. Automation, for example, is spreading across the whole manufacturing and supply chain process, including logistics and packaging, as well as the design of buildings and tools.

Although in the early stages of their development, these five areas of the tech sector should all benefit from the development in blockchain technology – an area which is currently attracting a lot of capital and talent.

Across our five conviction sectors, we believe that private markets offer a rich selection of investment opportunities, and the potential of very attractive risk-adjusted returns.

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Stanislas Chanavat

Investment Manager Thematics, Pictet Alternative Advisors