Pullback reveals bargains in US tech sector

ANALYST VIEW / After spectacular outperformance following the Covid-19 pandemic, the US technology sector underperformed the market in the first quarter of 2022, with many companies performing far worse than the overall sector. Nonetheless, technology's performance still exceeds the overall US market on a trailing 12-month basis.

We're still fond of secular tailwinds associated with cloud computing, 5G, and the "Internet of Things." Thus, we view the technology pullback as healthy and would point investors toward high-quality wide-moat software companies, such as Salesforce.com CRM, ServiceNow NOW, and Adobe ADBE, among others.

As of March 25, the Morningstar US Technology Sector Index was up 22% on a trailing twelve month basis, outperforming the US equity market, which is up 14%. Over the past quarter, technology underperformed the broader market, down 10% compared with the US equity market's decline of 5%.

The gap between tech and the broader market narrowed in Q1

Source: Morningstar

As of March 25, the median US technology stock was 6% undervalued, a sharp reversal from a sector that was overvalued by 6% and 14% one and two quarters ago, respectively. Yet, while the high number of undervalued mid- and small-cap stocks lowered the median valuation, on a market-capitalisation basis, overvalued large-cap stocks bring the tech sector into fair value territory.

Software remains the most attractive subsector. High-flying growth stocks from 2020 have crashed, and many now trade well below our fair value estimates. Meanwhile, more mature, higher-quality software stocks have also sold off and now provide investors with an attractive margin of safety. Many semiconductor firms are also undervalued, while hardware is fairly valued.

We see buying opportunities in software and semiconductors

Source: Morningstar

In software, IT departments have been focused on digital transformation, first from the secular shift to cloud computing and software as a service, followed by the coronavirus pandemic and the critical rush to implement remote working tools. We foresee enterprises using software to modernise all types of business processes, in turn leading to software industry growth at a low-double-digit compound annual growth rate.

The cloud opportunity is the most obvious secular theme in software

Source: Morningstar

Additionally, we see an ongoing data boom that not only bodes well for cloud computing, but also database management systems. Traditional databases like Oracle's ORCL still have their place, but emerging beneficiaries will be companies with premier data-lake, data-warehouse, and data-marketplace offerings, such as Snowflake SNOW and MongoDB MDB.

The explosion of data, including DBMS revenue, should not slow down

Source: Morningstar

Top picks

Salesforce.com CRM
Star Rating: ★★★★★
Economic Moat Rating: Wide
Fair Value Estimate: US$320
Fair Value Uncertainty: Medium

We believe Salesforce.com represents one of best long-term growth stories in large-cap software because of its ever-expanding portfolio of complementary solutions that allow users to completely embrace their customers, thereby building relationships, strengthening retention, and driving revenue. In our view, Salesforce will benefit further from natural cross-selling among its clouds, upselling more robust features within product lines, pricing actions, international growth, and continued acquisitions, such as the recent deals for Slack and Tableau.

ServiceNow NOW
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: US$700
Fair Value Uncertainty: Medium

ServiceNow excels at executing the land-and-expand strategy, and it continues to use its strength in workflow automation to penetrate existing customers more deeply in IT and more broadly with HR, customer-service-specific, and other back-office products. We expect both tiered offerings and vertical-specific versions to continue to provide a nice tailwind to revenue. We think ServiceNow has become a key partner in digital transformation, as shown in retention statistics, which remain at the elite level. We are impressed with ServiceNow's excellent balance between strong and highly visible revenue growth and robust and expanding margins.

ASML Holding ASML
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: US$800
Fair Value Uncertainty: Medium

ASML is one of our top semiconductor picks thanks to the increasing adoption of extreme ultraviolet lithography at large chipmakers such as TSMC and Intel to support explosive chip demand. Although the firm's first-quarter outlook is negatively affected by supply chain constraints, we think ASML will outgrow the wafer fab equipment industry in 2022 (20% revenue growth versus 15% for WFE). With TSMC, Intel, and Samsung all vying for process technology leadership, we expect ASML to be a primary beneficiary because it sells tools to all three chipmakers.