High-Quality Tech Stocks Remain Resilient

October 23, 2023 8 min 14 sec
Robertson Velez, CFA
CIBC Asset Management
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Welcome to Advisor ToGo, brought to you by CIBC Asset Management. A podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Robertson Velez. I’m a portfolio manager at CIBC Asset Management.

At the start of the rate hikes in 2022, there was a marked change in the direction of interest rates after years of quantitative easing due to fears of rampant inflation in the anticipated Fed response.

The general view was that equity values needed to be brought down because a higher discount rate reduces the present value of future cash flows, so those securities should be worth less relative to cash and bonds. And because technology stocks had higher growth in general, the free cash flow expectations over the long term were a bigger part of the valuation. So, tech stocks were considered long duration assets and were impacted more by this revaluation. And so the whole market declined in 2022, with tech stocks declining even more.

But here’s the question that many investors started to realize was much more important. What is the real impact of higher interest rates?

Here’s my view. If a company relies on debt to finance much of its operations or it is unprofitable and needs to raise money, then higher interest rates mean lower profitability, or in the worst case, it could lead to bankruptcy. And this is the real risk if rates stay higher for longer for most companies. Many large cap tech companies have very little debt, generate significant free cash flow and continue to grow revenues even in a challenging environment. Moreover, they have shed significant costs in anticipation of weakening macroeconomic conditions brought on by the higher rates, so they are now leaner and more competitive. These companies are less impacted by higher rates and had been overly discounted in the selloff.

So, the market recognized this discrepancy earlier this year for a small number of large-cap tech stocks that are very high quality in nature, and they have pretty much driven the broad index returns year-to-date up to now in October.

Another factor that drove returns for a few stocks this year was the introduction of generative AI at the beginning of the year by Microsoft, followed by the strong demand for infrastructure equipment reported by Nvidia.

Many believe it was generative AI that drove returns for some tech stocks this year. My view is that while I do agree generative AI’s potential for significant growth, many of the quality tech names were so undervalued at the beginning of the year that there would inevitably have been some catalyst, whether generative AI or some other technology to drive up valuations.

So that’s my view of why these small number of quality tech names have outperformed so far this year and are no longer as sensitive to interest rate gyrations because, looking forward, these quality tech names are not really that impacted by interest rates. And looking out over the long term, regardless of what happens in interest rates, I expect that they will outperform the broader market.

In this environment, I would look for quality names in tech, and by that, I mean companies that have high revenue growth, high free cash flow margin, and high return on invested capital. Over time, these factors lead to outperformance because of virtuous cycle of revenue growth at high margins driving high free cash flow that can be reinvested at high return on invested capital driving even higher revenue growth.

So where can you find these qualities in tech companies?

What I look for are companies that have sustainable competitive advantages in their industries. Which can come from, one, opportunities for platform expansion. By this I mean companies like Apple and Microsoft that can grow their platform through user growth or higher pricing because of their strong position in the market. Two, technology leadership. An example of this is Nvidia that has a clear technological advantage in its space. Or three, structural changes in the industry, such as M&A or restructuring. An example of this is Broadcom, that’s grown through many successful acquisitions.

What I would avoid are unprofitable tech companies or tech companies that have significant net debt that is not easily serviceable with their free cash flow generation. In a high interest rate environment, these stocks will continue to be pressured.

Examples of this are many of the small and mid-cap companies in technology, which have very high growth rates, and where we have seen that the price shot up through the pandemic period but have come down and have not really recovered. And the reason is because most of these companies are unprofitable, and they would require injections of new capital in order to sustain their growth. So, I think that there are many examples of these types of companies, and I think at the right point in time, when we do see a change in the environment, they may become more suitable for investment, but at this point, I would tend to avoid them.

If central banks start cutting rates, then I think tech performance broadens out. So, I think tech will still outperform, tech generally outperforms in a lower interest rate environment, but I think that performance broadens out to smaller companies that have more growth than profits, and these companies will start to become more attractive as running out of cash becomes less of a concern. Companies that have a high level of debt service costs will also benefit as lower interest rates will drive up margins.

So, I think what you may be asking is if I would be shifting strategies if central banks start cutting rates. My focus on the science and technology fund will always be on quality as defined by revenue growth, free cash flow margin and return on investment capital. But what may happen, though, is that the opportunity set for quality companies may broaden out in a more supportive interest rate environment and I’ll invest more in the mid-cap and the small-cap names or international opportunities that may have more potential for outperformance as we get into that environment.

The more supportive environment when interest rates start coming down, I think there are many opportunities in the global market where they may present a better upside than U.S. companies. And I think that, in that kind of environment, I think the portfolio would broaden out to include many of these international technology companies.

I think that there is a lot of concern right now that technology may have run up too much, specifically these magnificent seven names, which are the large-cap quality tech names that have outperformed this year versus the broader market.

But I think you have to look at it from the context of where it had been after the big selloff in 2022. Many of these names are just coming back up to where they had been prior to the downturn in 2022, and many have not actually reached those levels.

So I think we have to look at it from the broader perspective of the longer-term opportunity. I had mentioned the generative AI as being a long-term driver of growth, which I believe has still a long leg for growth in terms of the amount of infrastructure that needs to be built out, in terms of the software that needs to be developed and in terms of the services that can be provided by marrying data with large language models and being able to provide that to consumers through generative AI.

So there are a lot of long-term drivers of technology, and I think that there’s still a long runway for growth going forward regardless of the interest rate environment.