Markets & Economy
An Oasis of Investment Opportunity in a Low-Growth WorldDecember 30, 2016
- We favor fast-growing platform companies on the Internet; innovators operating in new areas, such as cloud computing; and businesses that are transforming industries.
- Some Chinese technology stocks are well positioned to benefit from China’s growing middle class, and we remain optimistic about China’s growth outlook.
- New technologies benefiting from the use of artificial intelligence and machine learning offer substantial growth opportunities.
- The incoming Trump administration’s immigration and trade policies could hurt the U.S. technology sector, though its position on lower taxes and repatriation of overseas profits could benefit the sector.
FIRST, WHAT IS YOUR APPROACH TO INVESTING IN GLOBAL TECHNOLOGY?
Given the magnitude and pace of change in the technology sector, early identification of companies with exceptional growth potential is vital to delivering alpha. Our strategy attempts to identify innovative and disruptive companies with strong intellectual property, high barriers to entry, a large addressable market, and accelerating fundamentals. Outcomes in technology investing are often extreme—“winner take all.” We place a particular emphasis on participating in extreme positive outcomes and avoiding extreme negative ones. In other words, being on the right side of change. Major themes that the portfolio is positioned to capitalize on include cloud computing, Internet platforms, and technology expanding into non-technology areas. Secular growth of technology in non-technology areas is a competitive advantage for the industry in a low-growth world.
MANY INVESTORS EXPECT GLOBAL ECONOMIC EXPANSION TO BE SUBDUED FOR SOME TIME. IS TECHNOLOGY INVESTING ONE WAY OF CAPTURING GROWTH IN THIS ENVIRONMENT?
Yes, I believe technology is one area able to drive its own growth through innovation, new products, and product cycles as well as market share gains. In a low-growth world, this is where the growth can be found. Overall, most industries and individual companies are going to find it difficult to achieve much expansion over the next decade if you accept, as I do, that macroeconomic growth is likely to be modest. We are seeing this in Europe and the U.S.—even China has slowed down. There are limited prospects for this situation to change dramatically—technology has the potential to be an oasis of growth in a global economy that lacks it.
Bearing this world view in mind, we have a preference for the faster-growing companies. We favor platform companies on the Internet like Google, Priceline, Netflix, and Alibaba in China. We also invest in companies operating in new areas of technology such as cloud computing, which is delivering computing technology over the Internet and has an element of both infrastructure and software. We also have exposure to companies that are transforming industries, such as Tesla Motors in autos. We have avoided enterprise hardware and other related technology equipment names given their slowing growth due to the disruption caused by emerging technology companies.
“Outcomes in technology investing are often extreme—‘winner take all.’ We place a particular emphasis on participating in extreme positive outcomes and avoiding extreme negative ones. In other words, being on the right side of change.”
HOW IMPORTANT IS CLOUD COMPUTING FOR THE FUTURE DEVELOPMENT OF THE INDUSTRY?
Cloud computing is one of our key investment themes. There are opportunities in the infrastructure companies such as Amazon Web Services, Microsoft’s Azure, and Alicloud in China that store and help manage companies' IT workloads. There are companies whose businesses are enabled by cloud computing, such as Netflix, Airbnb, and Uber. And there are software-as-a-service companies, such as Workday and salesforce.com, that run their own data centers but use the cloud to distribute their software.
This new group of software companies operating their businesses through the cloud delivery model are competing strongly with some of the major incumbent software firms, which have huge revenue streams. For the established software firms, generally speaking, it is a time of enormous disruption. The financials for incumbent software firms over the last two years have resulted in very little growth in new business. While established software companies benefit from the considerable streams of business from servicing the maintenance needs of existing clients, they struggle to add any new customers. This is because implementing a new cloud-based delivery model requires thousands of people working on giant projects, which is damaging to a company’s workflow.
The challenger software companies using the cloud to deliver their services are successful because implementation in terms of installation and updates can be performed quickly and with higher customization, which results in lower churn of the customer base. They are likely to grow for years to come, and—over time—the market cap differential between these firms and the more established players could be flipped on its head. Sometimes it is important to pay attention to the signs right in front of you. To me, the possibilities for cloud computing fall in this category. Years ago, at the time when the potential of the PC was obvious to many, there were tiny firms operating in this industry that, over a period of 10 to 15 years, grew to become the huge, household-name technology firms of today. I see the same opportunity in cloud computing.
TESLA MOTORS IS A TOP HOLDING IN THE GLOBAL TECHNOLOGY FUND YOU MANAGE. WHAT DO YOU LIKE ABOUT THE COMPANY?
I believe Tesla Motors—a U.S. firm that manufactures luxury electric cars—is one of the most innovative companies in the world. In my opinion, the company’s CEO Elon Musk is a successor to Steve Jobs in terms of innovation and transforming an industry. Not only is he an expert in technology but, similar to Steve Jobs, he is also an innovative thinker in terms of marketing, consumer focus, and inspiring loyalty among employees. These are all aspects that make a technology company special, and Elon Musk has infused these attributes into Tesla.
The total addressable market of the auto industry at over U.S.$1.5 trillion globally also provides an enormous runway for growth for an innovative company like Tesla. There is an internal energy at Tesla unlike anywhere else—certainly not in the auto industry. It is relatively unique, even among technology companies. Tesla did the hardest thing first: It made one of the best cars in the world on a shoestring budget. It just so happens to be electric. In 20 years, I would be very surprised if the vast majority of cars are not electric. I believe Tesla’s cars will be cheaper and better than the existing options.
Tesla has similar characteristics to other innovative technology firms. It offers an improved product and is not encumbered by a big dealer network. As for the incumbent automakers, history would suggest these companies will struggle. Past events have taught us that whenever we see structural changes in an industry, the leaders usually come from the outside. It is just too hard for incumbents to change and adapt—these companies have too much to protect, are usually beset by infighting, and are timid in terms of embracing change. These companies do not want to cannibalize their existing businesses.
Tesla is also a software company with autonomous driving. In fact, our original position in the stock was initiated during a period of volatility when the batteries were catching fire as they were too close to the road debris. Instead of taking the car into a garage, Tesla sent a software update to raise the car chassis to improve ground clearance—what an elegant business model. We know the growth of the company will not be linear. The stock is currently trading on delivery of cars. Longer term, the additional use cases in a very large auto-addressable market are enormous with autonomous driving and other related mobility as a service. We think that rapid change in the automotive industry is going to continue, and we believe Tesla is positioned to be a leader in that disruption.
HOW ARE YOU TAKING ADVANTAGE OF CHINA'S TRANSITION TO A MORE CONSUMER-LED ECONOMY?
I believe many investors underestimate the potential arising from China’s growing middle class. The Chinese technology stocks we hold are well placed to benefit from these trends. For example, Alibaba is the largest e-commerce platform in China. The company has high market share and strong cash flow. Mobile is a big source of future monetization for the e-commerce platform. (More Chinese have mobile phones versus personal computers.) Alibaba also operates Alicloud, which is like Amazon Web Services. The company has little competition in China, so it could have a virtual monopoly in cloud computing. We understand the economics of Amazon Web Services well and think cloud computing provides a growth vehicle for Alibaba in addition to being a very profitable e-commerce business. Online travel planner Ctrip.com International, China’s version of Priceline, has also performed well.
Overall, however, we are underweight the Internet sector, and Chinese Internet in particular, on current valuation concerns.
THE SLOWDOWN IN THE CHINESE ECONOMY IS ANOTHER WORRY FOR INVESTORS. DO YOU SHARE THESE CONCERNS?
Yes, the Chinese economy has slowed, but despite fears over its economic health, China remains one of the fastest-growing global markets. So I am optimistic about the outlook. The shift away from investment spending and toward domestic consumption is the right path to take. While we do not expect a “hard landing” in China as its economy transitions, we do anticipate that e-commerce growth in the country will slow from a blistering pace to merely a strong one.
WE HAVE TALKED ABOUT THE INVESTMENT POTENTIAL IN THE U.S. AND CHINA. WHAT TECHNOLOGY OPPORTUNITIES ARE YOU FINDING IN EUROPE?
We are overweight in Europe, and there are a few companies we own operating in businesses including chip design, semiconductor capital equipment, the provision of IT for the travel and tourism industries, and cable. These are really good companies in each respective field. NXP Semiconductors, a Dutch company whose largest end markets are autos and security, is attractive to us as it has diversified its markets beyond smartphones and is benefiting from broader industrial applications, such as technology in cars, infotainment, and the development of autonomous driving. Its security business will also become more important with the increasing use of chips on credit cards and for mobile payments. ASML Holding, another Dutch company, is a semiconductor capital equipment manufacturer serving companies like Intel and is also a top holding. ASML’s extreme ultraviolet technology continues to gain commercial appeal to semiconductor manufacturers to reduce the size of chip elements and improve chip performance.
Looking at software and the Internet, however, Europe has not developed a culture similar to California’s. Therefore, the Internet leaders in Europe are largely the same as in the U.S. But there are pockets of innovation in Europe that have developed, and we are taking advantage of them. The U.S. does not have a monopoly on innovation. The Brexit vote earlier this year does raise some concerns. It took a toll on Britain-based European cable operator Liberty Global, which earns strong cash flows throughout the Continent.
TECHNOLOGY FIRMS CAN SOMETIMES TAKE MANY YEARS BEFORE THEY START RETURNING CASH TO SHAREHOLDERS. HOW DO YOU VIEW THIS AS AN INVESTOR?
Each technology company has its own stage of life and should aim to make decisions in light of this. The more mature and well-established companies typically return more in dividends as opposed to stretching for growth that is going to be difficult for them to achieve. On the other hand, many of the younger companies need to be investing this cash to continue fostering innovation. The problem comes when companies still believe they can grow, even though their time in the sun has passed. By and large, most companies do not get this right. Many fail to accept that they are a mature business. However, with skillful management, the transition from growth company to mature incumbent that is managing costs and returning cash to shareholders can be made successfully.
TECHNOLOGY STOCKS PERFORMED POORLY IN THE FIRST HALF OF 2016 BUT REBOUNDED IN THE THIRD QUARTER. WHAT IS YOUR CURRENT OUTLOOK?
During the third quarter, technology earnings were surprisingly strong, particularly for companies benefiting from major trends such as the growth of cloud computing and the Internet. However, technology’s strong advance in the third quarter took us one more step away from the favorable valuation window that we had in the first quarter.
However, there are select cases among our leading positions where valuations have some headroom, potentially providing modest gains in the months ahead. We are also focusing on building up peripheral positions in small or newer companies with scalable market strategies that they can build upon through acquisitions. And we are paying particular attention to companies with ample free cash flow, which they could use for dividends as their technologies mature and growth slows.
President-elect Donald Trump’s impact on the technology sector could be mixed. The positions he espoused during his campaign on immigration and trade generally would hurt the U.S. technology sector if enacted by Congress. Technology is one of the most globally competitive U.S. sectors and relies on an influx of highly skilled talent from around the world and global supply and distribution chains. However, lower taxes, particularly on repatriated overseas profits, would be a positive for global technology firms that have billions of dollars parked abroad.
As always, we will try to take advantage of future volatility to add to our leading positions and to find new ones. Whatever the market environment, our extensive global analyst team and careful research process should enable us to continue to invest in standout companies.
WHERE DO YOU SEE OPPORTUNITY IN THE TECHNOLOGY OF THE FUTURE?
Our analysts are helping us keep an eye on where new technologies are being ushered into the marketplace. We are focusing on companies where artificial intelligence (AI) and machine learning (ML) and use of big data enable their businesses to grow and be more productive. AI and ML are key areas of investment across many sectors in the tech industry, including software, computing, IT services, consumer/media, and semiconductors. Google has been very outspoken about the use of AI and ML, and all technology companies are focusing on it as AI and ML will further advantage the massive players given a scarce talent pool and the importance of high-scale computing and data.
AI and ML should help the public cloud proliferate at an even faster rate. On the software side, it has been increasingly utilized by consumer-driven companies. Smartphones and consumer devices can be a key way to make AI and ML more broadly applicable, especially through use of personal assistants like Home, Google’s assistant; Alexa, Amazon’s assistant; and Siri, Apple’s assistant. AI and ML will be an important customer value and competitive dimension for companies outside of technology as well.
Many of these frontier technologies are likely to be folded into companies that are currently dominating markets, such as Internet retailing and social media. Google, Netflix, Amazon, and Tesla all have elements of this investible theme. The Tesla innovation in autonomous driving utilized AI, and Netflix and Amazon.com are essentially using AI and big data to provide customer recommendations.
There has been a lot of hype about the potential for AI/ML, but it is already proving to be a transformative technology with broad applications. It is the kind of disruptive technology that we are always looking to take advantage of as investors.
Call 1-800-225-5132 to request a prospectus, which includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing.
The securities mentioned represented 44.3% of the Global Technology Fund as of September 30, 2016. Alibaba, Microsoft, Airbnb, and Uber were not owned as of this date.
The fund is less diversified than a non-focused fund, and its substantial reward potential is coupled with significant risk. In addition, any foreign holdings could be affected by declining local currencies or adverse political or economic events.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of December 2016 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
T. Rowe Price Investment Services, Inc., Distributor.
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