We look at the domination of markets by US-based tech firms, and ask whether future innovation will continue to be concentrated in America. Where should investors look to for the next wave of tech innovation (and investment opportunity) – and is it necessarily going to come from across the pond?
Before the recent sharp correction in the technology sector, followed by a war in Ukraine that has sent shock waves across global financial markets, we were often asked if US equities were in a bubble. Bubbles are characterised by the divorce of asset prices from their fundamental value. The outperformance of US equities – and particularly America’s technology giants – for several years was driven as much by their earnings growth as by their valuation. Unlike tech stocks at the turn of the millennium, these companies generate billions of dollars of earnings growth, even though they also spend billions on research and development and other intangible items, which accounting rules don’t allow them to “capitalise” (effectively spread out over a number of years) and instead get subtracted from earnings immediately. Our research suggests that adjusting earnings and book value for what we call “knowledge capital” and “organizational capital” made their valuation multiples look far less lofty.
Much of the difference in the valuation of these American companies and more averagely valued companies in the global index was also explained by interest rates. American tech companies’ earnings are expected to grow at a higher rate for longer than the average company. That means more of their current price is determined by their future earnings, and so that price is more sensitive to the discount rate used to translate tomorrow’s earnings into today’s money. When interest rates were falling, American tech valuations were on the rise. None of this suggests a divorce of prices from reality.
From the start of this year, the prices of some more highly valued growth stocks – whose promises of stellar growth ahead have yet to translate into tangible profitability – have come under pressure as investors scramble to reposition themselves for rising rates. The rotation away from stocks like these has spilled over somewhat to impact some more mature and resilient American tech companies that are profitable today and whose high prices relative to their earnings reflect investor trust in their ability to reliably increase their profits faster than GDP growth. We believe these sorts of businesses should rebound once the unpredictable forces currently dominating financial markets begin to ease and that such ‘growth’ companies with high-quality and highly profitable business models should continue to be a part of our investment strategies.
That said, we still see numerous new technologies coming to the fore in the years ahead, and we must ask whether they will continue to be dominated by the US tech giants? Of course, the US tech sector is and will remain a big driver of innovation and overall earnings growth, but future investment opportunities could be spread more widely.
A competitive advantage
Ever since the post-COVID recovery began, investors have been trying to comprehend the path of inflation and monetary policy and its implication for stock market leadership. For long-term investors, it makes sense to focus on companies that can benefit from durable competitive advantages.
Research by Goldman Sachs suggests that opportunities for investing in these future “innovators, disruptors, enablers and adapters” can be found across virtually all sectors, including retail, healthcare and other more traditional industrial sectors. For example, the green energy transition, now with the additional catalyst of the desire to boycott Russian oil and gas, could have the effect of amplifying innovation and disruption in industries like energy, utilities and industrials and transportation. Companies already using technological innovation to help drive the green transition can be found across a wide spectrum of industries and geographies, from small hidden gems to large established brands.
Goldman’s research suggests the split is fairly even across North America, Europe and Asia. That compares with a much greater US concentration of about 60% in the current makeup of the MSCI World Index, for example. Another case for having an active investment approach, rather than passively tracking an index.
More winners to choose from
A repeated question in recent years – which has been amplified by the pandemic – is whether investors are at greater risk of relative loss if they don’t pick the winners. This has tended to be shorthand for that elite club of US tech giants. What the question boils down to for investors is whether the largest earners are increasing their share of total earnings – or what we might call winner takes all. Research we conducted in 2019 showed that, while the share of the largest earners was indeed large, it hadn’t changed much over the last 30 years. If anything, that share had been decreasing in more recent years.
While we’re not claiming to have found the winners of the next 10, 20 years or more, we believe there is good reason to think there will be plenty of opportunity across many and varied sectors, and in lots of different places. That’s good news for active global investors like ourselves, as well as for our charity clients.
Andrew Pitt is head of charities at Rathbones