Equity markets made further gains in February; the FTSE World Index increased 3.9% (in GBP terms). Volatility remained subdued and markets ground higher, supported by robust economic data. The US economy is performing well: the New York Federal Reserve’s real-time estimates suggest 3.1% GDP growth in Q1 and consumer prices are rising at the fastest rate since 2012 whilst small business optimism and hiring intentions have spiked sharply (NFIB surveys at 12-year highs). As a result, the US Federal Reserve is taking an increasingly hawkish tone. FOMC Vice Chair Bill Dudley summarised “the case for monetary tightening has become a lot more compelling”. Financial markets moved to reflect this – the implied probability of a March rate hike has increased from 50% to 90%. Economists now estimate this may be the first of three or four rate hikes this year. The US Dollar rose 1.6% in the month.
Global economic data was also robust. The JP Morgan Global PMI rose for a fifth consecutive month and hit a 22-month high in January. Economic expansion was fastest in developed markets as the pace of Eurozone growth picked up. February saw the largest monthly rise in Eurozone employment since 2007, and the Markit flash PMI hit 56, the highest since April 2011. Chinese economic data remains harder to read. While China’s composite PMI fell, corporate business confidence hit its highest level in a year, suggesting that the recent slowdown may only be temporary. January’s new loans in China were the second highest ever at 2.03 trillion Yuan while new data showed that Chinese bank assets grew 15.8% in 2016 (to 312% of GDP).
US reporting season is now largely complete, with both revenues and profits coming in modestly ahead of expectations. Donald Trump reminded investors that tax reform is still on the table, announcing that he would announce something ‘phenomenal’ in the next two or three weeks whilst he is also expected to sign an executive order that could lead to an uplift in cybersecurity spend.
The technology sector outperformed during February, the Dow Jones World Technology Index rising 5.3% (in GBP terms). Sector strength was broad-based, with both next-generation stocks and legacy names performing well. Apple, the world’s largest company by market-cap, was a particular outlier, rising 13% in the month. Investors have begun to speculate on the potential new features in the iPhone 8 (or iPhone X as it may be called) and are anticipating another large upgrade cycle. A glass/aluminium chassis, OLED screen, wireless and rapid charging, 3D sensing, facial recognition and potential augmented reality (AR) are all being touted as possible features in Apple’s tenth anniversary edition with the highest specification device expected to price at over US$1000. Morgan Stanley speculated on a so-called iPhone super-cycle and raised their FY 2018 iPhone unit forecasts to +21% year-over-year (y/y) unit growth. Unsurprisingly Apple’s supply chain rallied amid the excitement of this major re-platforming. Fortunately, as discussed last month, we had pre-empted this and increased our Apple exposure via common equity, and also an out of the money call option position which had a notable positive impact on performance during the month.
February was another excellent month for next-generation technology fundamentals. Amazon won FastCompany’s most innovative company of 2017 with Jeff Bezos cooing ‘I have the best job in the world because I get to work in the future’. He highlighted Amazon’s focus on streaming, saying ‘our customers listen to a lot of music and we have a couple of freight trains kind of pulling the business along. One is Prime and the other is Echo and Alexa. It was revealed that Amazon is in early discussion to launch a paid channel to rival HBO, while Amazon Studios won its first Oscar as Manchester by the Sea scooped the top prizes for best actor and best original screenplay. Meanwhile, as Amazon’s Go concept-store continues to send ripples across traditional retail, Jeff Bezos was forced to deny an article which claimed that a planned two story supermarket may be staffed by as few as three on site personnel. Most importantly, Amazon reported strong quarterly results, with AWS its cloud computing business growing at a healthy 47% (impressive given its annualised US$14bn run rate). It is no wonder legacy IT providers are struggling with cloud deflation with Amazon, Microsoft, Google and Alibaba all offering computing on demand, at circa a fraction of the total cost of ownership (TCO) of traditional on-premise architectures.
Amazon is not alone in reshaping (digital) media consumption. Netflix beat expectations with c.93million+ subscribers – making substantial gains in viewership in January – its audiences were 38% above the average of 2016. Music streaming leader and IPO candidate Spotify hit 50million subscribers in February. Facebook is in talks to live-stream one major league baseball game a week next season, Mark Zuckerberg sharing his view that video is a ‘megatrend’. He also wrote a new mission statement for the company, calling for Facebook to become a ‘social infrastructure’ for users. Facebook reported excellent results, revenues grew 54% in constant currency as it hit 1.9 billion monthly active users (MAU), 1.23 billiom of whom are daily active users (DAUs). In a sign of strength, for the fifth consecutive quarter both ad impressions and the effective price per ad increased together. Facebook’s WhatsApp hired its first COO, as it starts to monetise its 1 billion+ MAUs. Facebook rival Snapchat came public on a lofty multiple during the month – signalling that the IPO window for next-generation assets is emphatically open. We chose to sidestep the deal because we only participate in a small number of IPOs where we have high conviction.
There was also a significant amount of positive news flow relating to Machine Learning (ML) and Artificial Intelligence (AI) - another theme (like Cloud computing) that we believe will transcend most industries. In a 20 day competition, an AI developed by Carnegie Mellon University beat four of the best Texas hold’em poker players globally. At the end of the competition Libratus had gained US$1.7m in chips, while all the other players were in negative territory. This victory is another major milestone in AI with implications across technology, both in the short-term (web search, advertising, ecommerce, finance & media, as well as online gambling!) and in the medium/long-term (software, security, medicine, robotics and pretty much every knowledge based industry). Industry expert and COO of Baidu, Andrew Ng, summed up the growing excitement in an article for the Harvard Business Review, ‘I have a hard time thinking of an industry we cannot transform with AI’. Google has released its production-ready machine learning TenserFlow software while making Nvidia Graphics Processing Units (GPUs) available on its Google Cloud Platform – a move replicated by Amazon leveraging both GPU and Xilinx Field Programmable Gate Arrays (FPGA’s) - enabling users to accelerate a variety of computing and analytical workloads. In its quarterly results, Nvidia announced its data center revenues grew over 200% y/y, driven by the growth in AI and cloud computing. AMD beat expectations and guided strongly, riding the same secular trend in GPU compute and share-gains from a revitalised Central Processing Unit (CPU) and GPU product roadmap.
February was also a busy month in the payments industry. AppleInsider revealed that Apple Pay is now accepted by 36% of US merchants, while Amazon revealed that its proprietary Amazon Payments service was used by 33 million customers last year (c. 10% penetration of Amazon’s user base). Visa reported strong numbers as core revenues accelerated. Tencent’s WeChat users sent 46 billion digital red packets over Chinese New Year (+43% YoY), a new record. New data from iResearch showed that there were US$4.4 trillion in Chinese mobile payments in 2016, almost 50x more than in the US. Elsewhere in Asia, Softbank announced it has nearly closed its US$100bn tech fund while Samsung scion Jay Y Lee was questioned by investigators in a Korean graft scandal. Despite the noise Samsung’s shares hit an all-time high on strong DRAM/NAND pricing and expectations of a significant ramp in OLED revenue/profitability (tied to the next Apple iPhone).
Small and mid-cap company fundamentals were solid in February. ServiceNow delivered a break-out quarter, as non IT Service Management (ITSM) products inflected higher. New Relic billings grew 33% as it broadened out beyond Application Performance Management (APM). Hubspot, Shopify & Talend all beat and raised, while Zendesk got back on track with a billings reacceleration. Splunk grew revenues 39% and reiterated its US$2bn 2020 revenue target. MindBody delivered strong growth and has begun to position itself to bring significantly greater value to its customers. Two of our smaller holdings in security proved the only weak spot as Palo Alto Networks guided down blaming changes in the sales organisation, and Vasco disappointed (both subsequently sold). Among legacy players, Cisco reported its fifth straight quarter of revenue declines and Intel took a knock as it was revealed that Apple are developing ARM-based chips to work alongside Intel chipsets in their Mac laptop range.
In a sign of the times, Lady Gaga used a swarm of drones as her ‘backing’ in her half-time performance at the Super Bowl. New technologies are emerging and being adopted at an ever faster rate. Fourth-quarter earnings season and fundamental data-points in February bore testament to this acceleration in technology proliferation. Winning companies are creating huge value as they ride disruptive technology trends. After years in the wilderness it is becoming increasingly clear that artificial intelligence (AI) and machine learning are emerging as the next great technology platform – they are already beginning to disrupt most industries. One AI expert argued this month that ‘AI is the new electricity’. Tech companies such as Google, Facebook, Microsoft, NVIDIA and Baidu are the early leaders/disruptors – they will continue to reap the benefit of these explosive trends along with others such as AMD, Xilinx and Salesforce.com (who a few days ago announced a collaboration with IBM Watson around AI). On the other side of this trade, legacy companies look increasingly stranded as they are unable to participate in this new world of computing.
After two years of multiple compression we feel confident that our portfolio is well positioned with our excess growth likely to manifest as outperformance should valuation multiples hold constant or expand from here. Although the US market is at highs, many of the higher growth technology sub-sectors (Internet, Software as a Service (SaaS), Cybersecurity and Cloud software) are trading at or below their five-year averages. Current premiums paid for secular growth appears low at a time when technology is becoming increasingly disruptive. This likely explains the elevated level of M&A last year which after a brief Q4 pause (around US elections) has recently resumed with Cisco buying AppDynamics for US$3.7bn (a 100% premium to its expected IPO price) and Hewlett Packard’s acquisition of Nimble Storage for US$1bn, a 45% premium. Technology’s expanded addressable market significantly enhances the opportunity-set for leaders exploiting disruptive technologies to go after historically sheltered profit pools of other industries. At some point it seems likely that this will lead to the re-rating of our secular growth stocks. As a result, despite a strong start to the year, we remain optimistic that we can deliver good absolute and relative returns in 2017 and beyond – as such we intend to remain relatively fully invested and will look to use any market setbacks to add to our preferred positions.
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