Some of the biggest names in global technology are significantly overvalued, but cloud computing and M&A activity are creating investment opportunities.

Overall, we view the technology sector as overvalued at a market cap-weighted price/fair value of 1.08 as of the end of November, versus 1.09 at the end of August and 1.13 at the end of May.

As of mid-December, the Nasdaq Composite has risen about 7 per cent from mid-September and is up about 28 per cent year to date. Apple is leading the way, calling for healthy iPhone orders during the holiday season.

Although we think iPhone unit sales (split this year among the iPhone 8 series and the high-end iPhone X) will be relatively flat versus the holiday season a year ago, higher prices associated with the iPhone X should drive nice revenue growth for Apple.

Semiconductor business conditions have remained strong in recent months, with robust demand from the automotive and industrial sectors in addition to demand from Apple. Enterprise software and IT services are interesting growth sectors to us, and we see a handful of undervalued names there.

Tech bellwethers Apple, Facebook FB , Oracle ORCL , Taiwan Semiconductor TSM , and Intel INTC all appear modestly overvalued to us. Alphabet GOOG / GOOGL appears fairly valued, and we see a decent margin of safety in Microsoft MSFT.

In general, we believe valuations across tech are painting overly rosy scenarios for new and emerging technologies around artificial intelligence. Nvidia , for example, appears significantly overvalued to us.

It's in the cloud

In our view, the single most important trend in technology is the shift toward cloud computing, which we think has ramifications for dozens of stocks across our coverage. Both startups and enterprises, in an effort to reduce the high fixed costs associated with running on-premises IT hardware and software, are shifting more of their workloads to infrastructure-as-a-service vendors such as Amazon Web Services, Microsoft Azure, and Google.

Internet-as-a-service vendors, along with software-as-a-service vendors, are seeing tremendous growth, while legacy IT vendors face headwinds. Adobe Systems ADBE and Microsoft have been especially adept at transitioning to the SaaS model, as selling subscription software, rather than charging for up-front licenses, has expanded their customer bases. Oracle, for one, has been relatively slower to pivot, in our view, albeit with some signs of optimism at times.

Another trend in technology remains mergers and acquisitions, with Broadcom making an industry-altering attempt to buy QualcommQCOM in what would be tech's largest deal ever, if completed.

Enterprise software has always been an area where vendors pair up to offer more-robust services to their customers. Cisco SystemsCSCO appears likely to make more deals to bulk up its software offerings, while Apple continues to buy smaller tech firms in order to bring new technologies in house, with the reported $400 million deal for Shazam being its latest move.

Across our coverage universe, we still see some value in SaaS providers such as Salesforce.com CRM , ServiceNow NOW , and Workday WDAY . These firms should continue to gain market share and see outsize revenue growth over the next decade as they ride SaaS and cloud tailwinds.

As we look beyond the next one to two years, future spending by SaaS leaders should be for customer retention, which is far less costly than customer acquisition. We foresee many SaaS vendors benefiting from tremendous operating leverage and earning robust profitability, similar to software leaders like Oracle today.

On the other hand, semiconductor equipment makers are some of the most overvalued names in the tech sector.

Business conditions have been terrific in recent quarters, predominantly as memory chipmakers expand capacity and leading foundries invest in new manufacturing technologies such as extreme ultraviolet lithography. However, we don't expect these good times to last forever, and we view a number of leaders in the sector as fundamentally overvalued.

More from Morningstar

5 mindset shifts to give your portfolio a nudge

4 medal-rated listed investment companies

Make better investment decisions with Morningstar Premium | Free 4-week trial

 

Brian Colello, CPA, is a senior equity analyst for Morningstar, based in the US.

© 2018 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.