CIO Insights – Stock Picking in Big Tech

09.25.20

Valuation and antitrust concerns underscore the importance of an active approach

Dan Hanson: As we look at the current market environment, large-cap technology companies have been the main driving force behind performance this year. Obviously, it’s been a volatile year thus far, with the S&P 500 Index, NASDAQ and Russell 2000 Index returning 3%, 21% and -10%, respectively. In those three numbers, you get a sense of the extreme spread between different parts of the market's performance. The S&P 500 Index’s positive performance has been mainly driven by large-cap tech companies, while the Russell 2000 Index of small-cap companies is reflecting the challenged environment from the pandemic-driven slowdown.

One notion we are considering is whether the market is ahead of itself. And is that why the correction happened, given the challenges in the economy as a result of the shutdown? As we look at the data right now, we see strong fundamentals supporting the leadership of large technology companies. We also believe the NBER will officially proclaim the end of the recession, eventually making it one of the shortest on record. Historically, if you look at prior recessions, the duration of the recession is proportional and a link to the nature of the recovery. The shorter the recession, the quicker and more robust the recovery. Given the extremely short, albeit severe nature of this slowdown, we think a V-shaped rebound is in the offing and strong market performance broadly is consistent with that view.

When we look at valuations, 77% of the S&P 500 Index constituents have earnings yields higher than the 10-year U.S. Treasury yield. Additionally, double-digit trillions of dollars of global bond are trading at negative yields, while U.S. real rates are negative. So, on a relative basis, leading businesses that can grow, despite this slowdown, are demonstrating strength and driving the market rebound, which is what technology companies are illustrating.

Brad, the fundamentals have been quite strong for mega-cap technology businesses. What's your response to the belief that valuations are ahead of themselves in a nosebleed market, or do you think this is more of a rational situation in terms of market leadership?

Brad Warden: A lot of parallels are trying to be drawn between today’s tech valuations and the valuations in the late-1990s. We take a different view on that – the underlying business models of the large tech companies that are doing well are very different than what was occurring in the late 1990s. Based on the margin structures and cash flows of today’s leading technology companies – I would argue that we were undervaluing these business models earlier in the year and during selloff in March. Additionally, I think the resilience of the business models, the management acumen, the ability to deal with the changing environment and the utilization of technology across those models was being underappreciated. I think that is becoming more apparent as we continue to work through the pandemic.

We’ve obviously seen the stocks of large tech companies get bid up some, but I don't see extreme valuation. I'd argue we're closer to fairly valued now. Now it's a matter of looking forward on a sustainable basis and evaluating how much these companies continue to grow and determining the underlying risks to the business models. The bottom line here is that while the valuations have moved up, we continue to be comfortable owning large tech names. We think they will continue to be leaders not only in technology, but across the economy and in the markets.

Dan Hanson: One of the pushbacks to that view would be the notion that Big Tech is way over their skis and getting ahead of themselves. What's your reaction to that view?

Brad Warden: Thinking about big technology stocks in a singular fashion is very dangerous because I do think you must look individually at the quality of management, their ability to execute, and their governance issues. Lumping them together, you see varied performance across the group as well. I don't think necessarily lumping them all together is the right way to think about it. We assess individually each business model, each management team and their underlying ability to continue to grow. Certain business models have been discounted more heavily by the market, which we believe is correct. And then there are areas of opportunity where we think the discount level is out of whack. Overall, each of these models are different with different risks and different management teams that have shown varying abilities to maneuver through challenges over the course of time.

Dan Hanson: I think that makes the point that this is a unique time in economic history and these mega cap tech firms have had such a flywheel effect, where the business models have a commonality, but they're very differentiated business models. And that is where stock picking comes into play.

Brad Warden: I think that's an important point, too, as I think if you consider these business models, they are building a compounding advantage within technology. I think that's something that has caught the regulators attention, too. It’s not that these companies are building massive businesses based on merger and acquisitions – they’re building market power and compounding what they have at their fingertips. Whether it’s data and analyzing available data, or using artificial intelligence or machine learning, the companies are enhancing their businesses and creating higher returns for shareholders. I think that's something that is important as we analyze and break down the fundamentals of these businesses. They have built a moat and an ability to compound that advantage into the future.

Dan Hanson: A big part of analysis as a fundamental active manager is understanding the regulatory factor, such as overt regulation and Federal Trade Commission antitrust concerns, or whether there’s more social license operate. For example, is the company in the good graces of the public and viewed as a responsible actor, or are you viewed with suspicion, such as TikTok. Could you touch on your view as an investor of regulatory antitrust concerns?

Brad Warden: We have spent a lot of time understanding the precedent. We’ve listened to Congressional hearings to understand the angles that the lawmakers are taking and how it could potentially impact business models. I think regulatory authorities really woke up initially in 2016 with the reports about potential hacking and how it may have impacted elections. As you listen to lawmakers, they want to make sure, first off, that the consumer is not harmed. That is hard to prove given many of the different things that are given almost free to consumers, or the cost of goods that have come down because of the ability to buy things online and have almost real-time delivery.

From an antitrust standpoint, we're trying to take a different angle in assessing the amount of power resting with the companies. When we analyze precedent, we look at the antitrust tests placed on companies in history, especially in the U.S. courts. In evaluating what's going on with the leading technology companies right now, we do think there is regulatory risk. Some of that is reflected in a few of the company's stock prices and some it is not, in our opinion, and likely should not be reflected there because we think that regulatory risk is less so.

We think ultimately, when antitrust tests are put in place and they start to challenge them in courts, some of the companies may have to adjust their business models to address some of the concerns. Fundamentally, we're looking at this issue on a company-by-company basis and the potential impact on the business models. We are assessing if they can continue to generate high returns, even with some of these antitrust-driven changes, to the extent there's something that could fundamentally impact margin structures, business and cash flow. That's where we're making sure that our holdings reflect our fundamental conviction level and point of view. I think there's still much to happen here. And it's something that we're watching very closely because it's absolutely one of the top risks for these large tech franchises.


Ivy Science and Technology Fund Top 10 equity holdings as a percent of net assets as of 6/30/2020: Microsoft Corp. 10.4%, Apple, Inc. 7.5%, Facebook Inc. 6.1%, Vertex Pharmaceuticals, Inc. 4.8%, Micron Technology Inc. 4.8%, Alibaba Group Holding Ltd. ADR 4.1%, Amazon.com, Inc. 4.1%, Aspen Technology, Inc. 4.0%, ASML Holding 3.6%, Cerner Corporation 3.5%

Index Description: The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.

Index Description: NASDAQ is an electronic exchange founded in 1971 that lists roughly 5,000 common stocks. The NASDAQ stock market comprises two separate markets, namely the NASDAQ National Market, which trades large, active securities and the NASDAQ Smallcap Market that trades emerging growth companies.

Index Description: The Russell 2000 Index is an index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. It is not possible to invest directly in an index.

Past performance is not a guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Sept. 11, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk Factors: The value of the Fund’s shares will change, and you could lose money on your investment. Because the Fund invests more than 25% of its total assets in the science and technology industry, the Fund’s performance may be more susceptible to a single economic, regulatory or technological occurrence than a fund that does not concentrate its investments in this industry. Securities of companies within specific industries or sectors of the economy may periodically perform differently than the overall market. In addition, the Fund’s performance may be more volatile than an investment in a portfolio of broad market securities and may underperform the market as a whole, due to the relatively limited number of issuers of science and technology related securities. Investment risks associated with investing in science and technology securities, in addition to other risks, include: operating in rapidly changing fields, abrupt or erratic market movements, limited product lines, markets or financial resources, management that is dependent on a limited number of people, short product cycles, aggressive pricing of products and services, new market entrants and obsolescence of existing technology. These and other risks are more fully described in the Fund’s prospectus.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.