Equity markets edged higher in March, extending their strong run, but local currency gains were largely offset by Sterling (GBP) strength – the FTSE World Index TR returning +0.2% (in GBP terms). European equity markets were particularly robust during the month, the main Euro Stoxx 600 Index gaining +2.8%. European politics took centre stage with UK Prime Minister Theresa May invoking Article 50, starting the two-year negotiation period of ending EU membership. Encouragingly, the election result in the Netherlands represented a setback to the populist momentum that led to Brexit in the UK and Donald Trump’s election in the US. The upcoming French election will be the next big test. Meanwhile, the US market lagged in March due to ‘reflation’ trade doubts. A failed attempt to repeal the Affordable Care Act has highlighted existing divisions in the Republican party, raising questions over President Trump’s ability to deliver on other campaign pledges such as tax reform.
Global economic data continues to portray a robust global environment supportive of risk assets. Sentiment indicators in the US continue to march upwards hitting multi-year highs in many instances. Some of the most eye-catching being the NFIB Small Business Optimism Index hitting its highest reading in 43 years and the US Conference Board Consumer Confidence Index climbing to its highest level in more than 16 years. The ISM manufacturing Index at 57.2 and ISM New Orders Index at 64.5 were both strong/expansionary. Positive data was not limited to the US – the Eurozone Composite PMI hit a multi-year high of 56.4, whilst in China the official manufacturing PMI rose to 51.8 (previous high 2012) and the non-manufacturing PMI rose to 55.1 (highest since 2014). In isolation the business and consumer surveys, known as soft data, suggest the global economy is expanding at the fastest rate since 2010 and that we are finally achieving ‘escape velocity’.
Hard economic data, for now remains mixed with US Q1 2017 Real GDP expected to be below 2% for the second successive quarter – although the aforementioned surveys are suggestive of H2 strengthening. This perhaps explains why the Federal Reserve (Fed) raised short-term interest rates by 25 basis points – bringing the target range to 0.75% to 1.0% – but accompanied by dovish commentary and ‘dot plot’ still suggesting only three 25 basis point increases in 2017. US auto sales volumes were soft for March at US$16.5m on a seasonally adjusted annual rate (SAAR). Credit conditions also tightened, as measured by falling US bank lending growth rates. Commodity markets were the laggards in March, the WTI Oil price declining 7% as optimism seemingly faded around the effectiveness of the OPEC production deal. All in, this mixed picture explains why 10-year Treasury yields only strengthened a few basis points (bp) to 2.40%.
The technology sector outperformed the broader market during the month, the Dow Jones World Technology Index gaining +2.8% (in GBP terms). A significant event in the technology world that largely went unnoticed, occurred during the month when Android (developed by Google) overtook Microsoft Windows as the Internet's most frequently used operating system. Web analytics company StatCounter estimated 37.93% of usage activity on its network came from Android users versus 37.91% for Windows. This ‘tipping point’ is another sign of growing mobile dominance of worldwide Internet usage. The hotly anticipated launch of the Nintendo Switch console also took place in early March with initial weekend sales in the US and Europe exceeding all previous Nintendo launches (including the Wii which went on to sell over 100 million units), yet another demonstration of the growing mass market appeal of gaming.
March tends to be a quiet month for technology sector earnings but several of our holdings (and a few large incumbents) reported results during the period. Tencent* delivered an in-line quarter – the company has significant future opportunities in the payment space, surpassing 600 million mobile payment Monthly Active Users (more than two-thirds of WeChat users). In Software, Adobe* delivered once again an impressive set of quarterly results. It was Adobe's seventh consecutive quarter of 20%+ revenue growth as the company continues to demonstrate it can drive both revenue growth and cost control in a very consistent manner – justifying its premium valuation. RedHat* also delivered an impressive set of results, closing several deals that slipped in the prior quarter, with 29% billings growth (the fastest in five years) and good traction from middleware and newer products.
Even results from software and services incumbents Oracle** and Accenture** were solid – supporting our view of a strengthening economic backdrop. Oracle reported a slight beat with decent cloud metrics albeit tainted by maintenance declines and an inorganic contribution from its Netsuite acquisition. Accenture results were in-line but accompanied by upbeat commentary regarding the H2 2017 outlook (and financial services spending). The only notable soft spot within software remains a subset of the security space (particularly on-premise vendors) with Palo Alto Networks* delivering a disappointing quarter/guidance.
An area of notable strength during the month was semiconductors, the Philadelphia Semiconductor (SOX) Index rising 3.3% supported by solid results and M&A activity. Micron** reported revenues and profits which exceeded expectations driven by strong demand and limited industry capacity additions (supply) for its DRAM and NAND memory chips. Optical component suppliers had a trickier month with Ciena**, Finisar** and Neophotonics** all coming in below expectations due to slowing demand/inventory adjustments largely from China.
The technology M&A wave continued during the month – to the benefit of the semiconductor industry – as Intel acquired Mobileye*, the leader in computer vision for autonomous driving, for US$15.3bn (a 30%+ premium). While the purchase should help Intel capture a share of the self-driving car market (which it estimates will be worth US$70bn by 2030) we reduced our position as incumbents making large M&A deals in non-core markets is often a sign of their waning confidence in their current positioning.
Elsewhere in hardware, Apple maintained its strong run and returned +3.8% in March. Anticipation continues to build for the upcoming iPhone 8 launch. Despite the recent stock performance, the valuation at less than 15x 2018E PE (or less than 13x ex net cash and sub 10x EV/FCF) still leaves the shares favourably valued when compared to the S&P500 multiple at 16x 2018E PE estimate.
While doubts remain about President Trump’s ability to deliver on his campaign promises, we believe the US economy has sufficient momentum without this additional stimulus. A strong/solid US economy is undoubtedly positive for many of our small/mid cap holdings, many of which by nature are over exposed to the domestic US economy. In addition, whilst our sector is unlikely to be the biggest beneficiary of proposed tax cuts or infrastructure spending policies it could be one of the biggest winners from changes to repatriation policies (on overseas cash/earnings).
Turning to technology stocks, the sector trades close to a market multiple and more importantly for us, many high growth technology sub sectors are trading around or below their five-year averages (on forward EV/sales multiples) significantly below their valuation peaks in early 2014 (the sector subsequently suffered two years of multiple compression). If valuations can hold at these levels, then growth should become the primary driver of stock performance. 2017 also looks set to be another strong year for M&A activity with the Trust already benefiting from small positions in two high profile technology deals so far this year (Mobileye*, Nimble Storage*). We expect the combination of compressed next-generation valuations and growing Cloud disruption to fuel further activity and provide valuation support for our small/mid cap growth stocks. While clearly above their long-term averages, equity valuations look appropriate given the inflationary backdrop, low interest rates and policy that remains supportive (for now).
What gives us the most confidence is the fact that our sector is continuing to disrupt many other industries, attacking previously un-addressable profit pools. The shift to public cloud computing remains in its early stages and brings with it significant productivity benefits. Technology is clearly changing both consumer and enterprise behaviour, and next generation companies (not easily accessible via ETF’s) should be the major beneficiaries of this change. If our thesis is correct, it should provide a multi-year tailwind for our growth centric investment approach at a time when technology indices may be weighed down by smartphone maturity and exposure to legacy technologies most at risk from Cloud deflation.
We expect this disruption to accelerate in the years ahead with Gartner predicting that on-premise (traditional) compute will account for only 20% of workloads by 2022 as compared to c.80% today. Having addressed key barriers to adoption such as security and vendor lock-in, the Infrastructure-as-a-Service (IaaS) market worth US$25bn today is expected to triple over the next five years. This is likely to prove highly deflationary as every US$1 spent at Amazon Web Services (AWS) is said to be equivalent to US$4 lost to traditional IT. This impact has already been felt in the US$21bn storage market which has contracted in value terms since 2014 despite >35% annual data growth. We expect this disruption to permeate well beyond storage/hardware, akin to the experience of client-server computing in the late 1980s/early 1990s that ended the dominance of the mainframe.
As in the past, this cheaper form of computing is resulting in an accelerating pace of innovation that is driving massive TAM (total addressable market) expansion. Aided and abetted by millennials that ‘engage with smartphones more than humans’, today’s technology winners are not peddlars of productivity dreams. They are the buyers, the mass producers of IT with which they deliver products and services that change user behaviour and expectations. Massive R&D budgets create formidable entry barriers and future growth opportunities that are unavailable to embattled incumbents.
At the same time – and following the experience of 19th century electricity – utility computing has eliminated many of the adoption barriers that previously disadvantaged smaller companies. Today, SMEs have access to the same cheap compute/best of breed software and are able to bypass traditional channels dominated by incumbents by engaging directly with their customers/targets thanks to smartphones and Internet advertising. Having levelled the playing field, it should be no surprise that the Internet-fuelled disruption promised in the 1990s has finally arrived.
This is an exciting time to be a technology investor. While we acknowledge the allure of ‘cheap’ stocks in an increasingly expensive market, we intend to remain invested in would-be winners rather than incumbents that have more in common with 19th century gas lighting suppliers than the technology winners of today. We look to a reopening IPO market to augment/refresh our portfolio of disruptive, TAM expanding would-be winners of tomorrow.
** Not held
*** Not held, not listed
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