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Choosing tech stocks as interest rates rise

October 5, 2022 6 min 31 sec
Tiffany Li
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Text transcript

Craig Jerusalem, senior portfolio manager at CIBC Asset Management

Tiffany Li, director at Rothschild & Co Asset Management.

After outperforming early in the pandemic, the tech sector has been hit hard by rising interest rates and slowing growth from COVID-related health concerns and [inaudible 00:00:25]. A few sub-sectors within technology, especially software and consumer internet, became overrated, and multiples went up dramatically early in the pandemic. It was under the premise that interest rates would stay low for long periods of time, and these technology companies would see accelerated growth from the COVID crisis. In hindsight, there was a lot of demand pulled forward, and now they’re decelerating due to cost comparisons, competition, and a slowing economy.

Tech multiples have been severely impaired this year. Most of tech is down between 20 to 80%. Many attractive, long-term growth stocks had major valuation [inaudible 00:01:15]. For example, Microsoft is down 27% year-to-date, despite growing earnings by 19%. The stock has seen a 38% multiple compression.

We still believe technology is the key to driving innovation and improving competitive edge in every industry. Longer-term, the technology sector will continue to disrupt various markets and generate attractive investment returns. Despite the technology sector’s recent under-performance, we believe there are attractive investment opportunities in the tech sector, and the market will be focused on fundamentals at some point.

There are some great businesses trading at very attractive multiples. For example, Alphabet is trading at 17 times earnings and nine times EBITDA. Meta is trading at 13 times earnings and six times EBITDA. Microsoft is trading at 20 times earnings and 14 times EBITDA.

Regarding adjustments we made for technology holdings, we’re not making changes for tech holdings purely based on macro and interest rate movement. We focused on stock-specific drivers, and we tried to find stocks that can outperform in a challenging macro backdrop and rising interest rate environment. For example, we added Multiple Web Solutions to our portfolio in February. Multiple Web Solutions is a provider of data and telecommunications equipment. The company is relatively insulated from cyclical headwinds and [inaudible 00:02:54].

There is continued monetization from first responder equipment. There is increased focus on public safety priorities. They’re taking shares in Chinese competitors, and state and local government budgets are healthy. At a little over 20 times 2023 P/E, we believe it is attracting value given its very stable and predictable [inaudible 00:03:19] of the revenue growth, and thus 10% EPS growth CAGR.

I also want to highlight some of the changes to Russell 1,000 Value benchmark that occurred in the annual June rebalance. Given the meaningful valuations we’ve set for growth stocks, a lot of them, especially in the tech sector, came into our benchmark. The technology sector weight increased by roughly 100 basis points, and the communications services sector increased by roughly 180 basis points.

For example, Meta, AMC, Netflix are some of the growth names that we added this year. And as follows, Alphabet, which was added last year, and, which was added the year before that. That could include some blue chip growth names that are well resourced and have a history of innovation. So, as relative value managers, the evolution of our benchmark is something that we need to monitor closely, especially from a risk management perspective.

In terms of what we look for now in tech in general, we look for companies with strong competitive positioning, revenue visibility, and highly revenue, solid free cashflow, and strong values and support. We are also looking for secular winners with increasing valuation. We’re seeking to take advantages of the valuations we’ve set and actual growth [inaudible 00:04:56] exposure.

In terms of characteristics we try to avoid. We try to avoid expensively valued, speculative, and possible companies with negative cash flow, and secular decliners and share losers that often become value traps.

Clearly, we think that valuation matters. The market no longer has the power for growth at any price, [inaudible 00:05:25] lose standing. Instead, we reward companies that are generating real cash flow and earnings. We continue to believe within the technology sector, innovation and share shifts can occur very rapidly. So we try to avoid investing in cheap stocks that are losing share because, again, those stocks often become value traps.

In terms of what needs to change to make the tech sector a less risky place for investors, first, we should caveat that investing involves risk. We think financial expectations need to come down and/or bottom out, so we could get past tough comparisons, and growth has to re-accelerate or at least stabilize. At a high level, rising interest rates are usually negative for long duration technology and growth assets. We believe interest rates need to stabilize for technology stocks to come back in favor.