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We'd welcome a pullback in overvalued tech: Morningstar

Brian Colello  |  06 Oct 2020Text size  Decrease  Increase  |  
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US technology stocks have significantly outperformed the broader market in 2020 and over the past 12 months. We're hesitant to say that tech is in a bubble, as we see robust fundamental tailwinds supporting future growth for most of our coverage, such as cloud computing, remote working, 5G network rollouts, and the "Internet of Things." But a pullback in tech stocks would likely be healthy, as we view the sector as largely overvalued, with few buying opportunities today.

As of 23 September, the Morningstar US Technology Index was up a whopping 38.8 per cent on a trailing 12-month (TTM) basis, vastly outperforming the US equity market, which is up 10.3 per cent on a TTM basis. Over the past three months, tech also outperformed the broader market, up 6.0 per cent compared with the broader US equity market, up 5.1 per cent.

chart 1

Tech outperformed the broader market in both the sell-off and rebound. - source: Morningstar

Earlier in the quarter, the median US technology stock traded at around a 15 per cent premium, which represents one of the frothiest valuations we've seen for tech since 2007. The median US technology stock now trades at a 4 per cent premium. We see very few buys today, similar to last quarter and even the months immediately before the pandemic. Hardware is still the cheapest subsector but it doesn't provide much value, as it's only 6 per cent undervalued. However, the higher-quality names we cover tend to be in semiconductors and software. Most buying opportunities in these sectors evaporated with the covid rebound, and the median stock in semis and software are now 7 per cent and 6 per cent overvalued, respectively.

chart2

Buying opportunities are rare in technology despite covid-19. - source: Morningstar

Independent of valuation, we remain especially fond of moaty software businesses, as these firms generate revenue on a subscription basis with little risk of cancellations, even as work shifts to homes and away from the office. Software was resilient during the credit crisis and has held up well in 2020 thus far. We continue to look at software as a bit of a safe haven in a covid, remote working world.

chart3

Sample of software firms in '08-09 point to robust revenue amid a recession - source: Morningstar

Cybersecurity also appears to be a bit of a haven. We've recently updated our security industry forecast but foresee minimal disruptions to prior spending patterns due to the pandemic. Besides their subscription revenue model, additional cyber solutions are being deployed as more people work remotely. The risk for bad actors disrupting data traffic won't slow down any time soon, so IT departments will remain proactive in monitoring its various software and solutions that each employee needs to be productive.

chart4

Cybersecurity spending should rise at a 9 per cent CAGR through 2023 - source: Morningstar

Top Picks

VMware VMW
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: US$202
Fair Value Uncertainty: High

We believe that VMware's position as the commonality between public clouds, private clouds, and on-premises ecosystems gives it an enviable position. In our view, the company has nicely made the transition away from relying on server sales and has established itself as a key player in more nascent high-growth areas. The diversification into markets such as container management, end-user computing, software-defined networking, and security should help insulate VMware from hardware spending pauses or softer virtualisation demand.

Palo Alto Networks PANW
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: US$305
Fair Value Uncertainty: Very High

Narrow-moat cybersecurity pure play Palo Alto Networks trades at an attractive discount to our fair value estimate. In our view, cyber threats do not yield to any global economic condition concerns, and the severely increased fines for data privacy woes and a dearth of talent within security make cybersecurity a top concern for enterprises. To supplement its firewall market leadership, Palo Alto aggressively built out a platform that contains cloud security and threat response automation. In our view, entities will favor adding on Palo Alto's security subscriptions over managing various vendors to alleviate toolset management burden.

Intel INTC
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: US$70
Fair Value Uncertainty: Medium

Wide-moat Intel trades at an attractive discount to our fair value estimate of US$70 per share. The chip titan's comprehensive product portfolio tailored to computers from the data center to the edge gives us confidence in the firm's long-term growth prospects, despite a declining PC market and a recent delay in the rollout of cutting-edge chip manufacturing. We applaud Intel's scattershot approach to address challenges in computing (artificial intelligence and cloud), connectivity (5G), and memory, while its acquisitions have unlocked new growth vectors outside of PCs and the data center.

is a senior equity analyst with Morningstar, based in the US.

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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