Time to Sell Tech?

Not if you own wide economic moat, high quality names.

Ruth Saldanha 12 January, 2022 | 1:18AM Ollie Smith
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As technology names globally correct, investors are worried about their holdings in the space. The Morningstar US Technology index has seen 17% of the stocks correct more than 50% off their 52-week high. For the Morningstar US Communication Services index, meanwhile, that number is at 22%.

But should you really worry about your tech stocks? We think not. In fact, there might be some attractive opportunities in the space. Editors Ruth Saldanha and Ollie Smith caught up with Morningstar’s technology sector director Brian Colello to ask him his views on the current situation. Here is an edited excerpt of that conversation.

Ollie Smith: The rout in tech stocks has been top of mind since the start of this week, but when did it actually start?

Brian Colello: Software stocks were definitely down at the start of 2022. There are a few reasons for that. For one, we've seen the US Federal Reserve point to tapering off, and an eventual reduction of bond buying. Additionally, US (and global) inflation has risen too. All of that points to rising long-term interest rates. In technology, and particularly in software, a lot of the earnings of these companies are going to be generated well into the future. So we are now in a world where we have higher interest rates, leading to a higher discount rate, which leads to investors being more likely to place a lower value on future earnings than they would have in a very low interest rate environment. And so we see software stocks selling off.

Ruth Saldanha: Some of these stocks are significantly lower than they were last year  17% of the stocks in the Morningstar US Technology index are more than 50% lower than their 52-week highs, and that number rises to 22% of the Morningstar US Communication Services index. Why are those stocks down so much, and should investors be concerned?

Colello: It’s a good question. We would have argued that, Zoom Video Communications (ZM) as an example, should have never been a US$700 stock, so that pullback is justified.

Our fair value estimate for Zoom has gone up over the past two years, because the company generated outstanding growth during the coronavirus downturn. But we think in in many cases investors got ahead of themselves on high growth stocks. You could attribute that to a couple of factors  one could be very low interest rates, and the other is very high liquidity.

Investors looked at the Fed’s views on stimulus and money printing, for instance, and considered the future of remote work, and that’s where they put their money during the pandemic. Now I hope we have some light at the end of the tunnel. We are going back to offices more often, and are leading to some kind of normalisation, and the trend that led to investors piling into remote working tools appears to be unwinding from our point of view.

These are still uncertain names because Covid-19 is hard to predict. So we have very high fair value uncertainty ratings on these names. Having said that, we also believe that investors may have overly sold off some of these stocks. We do see opportunities in names like Zoom, DocuSign (DOCU), and Zendesk (ZEN), where the sell off has been a bit too severe. DocuSign is probably our favourite of those three as it has a unique business model.

Saldanha: Some investors wonder if this a good entry point for the sector, or whether it is time to perhaps start taking profits. What do you think?

Colello: I can’t comment on whether investors should exit; that's up to each investors’ risk profile. In a scenario with a lot of uncertainty, we would focus on high quality names. There are highflyers in our coverage universe that did extremely well in 2020 and 2021, and in this pullback, some of those names are now cheap. We would probably point investors to wide economic moat, high quality software names that have been beaten up as a part of this sell-off. Salesforce.com (CRM) and Adobe (ADBE) are two standouts in our software coverage universe. Wide moat names have very sticky customers, very high quality businesses, medium fair value uncertainty, and have not sold off as much as the high flyers

Smith: Given the uncertainty around Covid-19, to what extent are companies actually in control of their own destinies? Some might say there’s never been a worse time to plan, in a manner of speaking.

Colello: That’s a reasonable assessment. Software is a very sticky business. Software companies with wide or narrow economic moats earn them based on customer switching costs. Look at it this way: software takes time to implement, there’s a steep learning curve (given that there's often mission-critical data or processes within a business that are transferred to that software), and to cancel a software seat or to rip it out to try and go to with a cheaper alternative takes a significant amount of work  and perhaps more importantly, downtime  that companies are loathe to do. Even at the start of the pandemic, when we moved to remote work we thought it very unlikely that companies would cancel or downsize their Salesforce or Adobe subscriptions. Even now, companies continue to retain that those software seats, if not expand them, as companies focused more on digital transformations.

Companies obviously can't control the coronavirus, but software was one of the areas where the product works, whether we are all in the office or working from home. Even in early- to mid-2020 we were writing that software was an area of relative safety, and high quality wide moat software names like Microsoft (MSFT), Salesforce and Adobe were buys. That has worked out, because no enterprises cancelled those contracts at all, and instead those companies still continue to grow as enterprises rely more and more on software.

So, to the extent that companies control their own software, they can control their own destiny, perhaps better than a lot of other industries certainly would. Once the software is installed with the business it's very sticky. What can be debated, and what can lead to volatility in the stock price, is how much room the business has to grow over the next five to 10, or 15 years, and what the world looks like at that point, and wat competition looks like.

That's where we have the most uncertainty. But we don't have much uncertainty about how these businesses do with existing customers — they are sticky with businesses, they retain most of their customers and far more often than not they are up selling what they sold in a in a prior year. We really like looking at cohort analysis, where. let's say a company sells $1,000 of software to a customer in year one, we might see that company sell $2,000 worth of software in year two, and $3000 in year three. Higher contract values with each customer each year is a good sign that that the software is sticky and the businesses value it.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Adobe Inc522.25 USD0.68Rating
DocuSign Inc50.97 USD-0.12Rating
Microsoft Corp446.34 USD-0.45Rating
Salesforce.com Inc231.81 USD0.58Rating
Zendesk Inc  
Zoom Video Communications Inc56.21 USD-1.30Rating

About Author

Ruth Saldanha

Ruth Saldanha  Editorial Manager at Morningstar.ca. Follow her on Twitter @KarishmaRuth.


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