From the Desk of the CIO: It’s in the price
Matt Wacher opines on the US IT sector.
Key takeaways
- Global regional diversification pays off
- Higher US IT valuations raise the bar for expectations
- Favour areas where valuations and expectations are lower
Global diversification continues to pay off for investors with several of our overweight equity positions – Korea, China, Japan and Brazil – performing well. Gains reflect companies and/or broad economic outcomes in these countries surpassing the low bar of subdued expectations.
On the other hand, high expectations tend to be harder to beat, so it’s natural for investors to review the stellar run in US IT stocks and ask if that can continue. Most of the rally in US equities has come from a re-rating of US IT companies which are focused on AI superscalars, strongly supported by blow away earnings results from select majors including Nvidia, and more recently, Cisco Systems. While other sectors have also risen, it’s US IT that has been the key driver of the US market because of its scale.
Morningstar’s recent review of the US IT sector explored in depth the key drivers of the industry’s growth, profitability and whether there is still value. Taking the long view, it is clear that the re-rating – investors paying more per unit of sales, cashflows or earnings – has supercharged returns over the past 5-10 years. Looking forward, the big players in software, hardware, semiconductors and IT services still have a great outlook in terms of the strategic advantages (using Morningstar “MOAT” definitions of competitive strengths) that can support faster growth and higher profitability than peers and other industries.
However, it’s worth noting that uncertainty levels for future earnings growth are also very high in many cases, as AI quickens the pace of change, and poses direct threats to several business models. Seen this way, we find the overall reward for risk not attractive for US IT, given full valuations, the fast pace of change and high levels of earnings uncertainty.
We continue to see better prospects in areas where lower earnings expectations are being priced in, such as healthcare, which have been hurt by US government regulatory changes and potential tariffs. Ultimately investors must consider what is priced in, as well as what is most likely to occur. On this basis we see less upside for US IT, and more upside for Healthcare and select Emerging Markets equities.
