News analysis

Tech still makes Asia tick

Despite the sector's recent volatility, Asia's tech firms have potential to expand

The world's technology stocks have become a force of nature. The United States' tech sector is up around 20 per cent so far this year, accounting for 10 of the top 20 performers in the S&P 500, while Asian IT stocks have outperformed the roaring broader market (MSCI Asia ex-Japan) by around 14 per cent, up 37 per cent year to date. But as share prices climb, murmurs of a dot.com-like bubble are seeping into investors' minds.

The debate over a possible tech crunch became more frenzied after the sector experienced heightened volatility in June. While the catalyst appears to be a general rotation into laggards and not a reaction to fundamental news flows, it still spooked investors who are concerned about the sector's long-term prospects. After all, share prices are at all-time highs and, in theory at least, what goes up must come down.

The gravity of technology companies, however, operates differently from other sectors. A major reason is that technology as a sector is no longer just about hardware and software. Household tech names such as Amazon and Apple are entering our grocery stores, cars, wallets, hotels and so on, while social media platforms and e-commerce platforms now boast hundreds of millions of users.

The evolution of technology companies broadening into cross-industry juggernauts and gobbling up market share from incumbent players is only just beginning. When evaluating the sector's meteoric rise and anticipating its future performance, it is therefore important to keep in view its short- and long-term potential.

FULL SPEED AHEAD FOR GLOBAL TECH

The recent tech sell-off could likely be a blip on the radar. Underlying demand and corporate fundamentals remain healthy, as evidenced by the recent string of strong corporate results among major software companies.

While valuations have expanded over the past few years, they are far from the extremes reached 15 to 20 years ago. At 18.5 times forward consensus earnings, the global tech price-to-earnings ratio is nowhere near the 2000 peak of 55.1x. Relative to the S&P 500, the sector currently trades at just a 5 per cent premium, compared with its 20-year average premium of 25 per cent. For comparison, the FAAMG (Facebook, Amazon, Apple, Microsoft and Google) group's valuation is only 22x, far below the 58x multiple for top five tech companies during the dot.com bubble.

A deliveryman for Chinese food delivery service Baidu Waimai, which belongs to search giant Baidu. Asian technology firms could likely spread into multiple segments and benefit from network effects, such as Chinese Internet firms diversifying into ar
A deliveryman for Chinese food delivery service Baidu Waimai, which belongs to search giant Baidu. Asian technology firms could likely spread into multiple segments and benefit from network effects, such as Chinese Internet firms diversifying into areas such as e-commerce and gaming.PHOTO: ST FILE

Large-cap technology companies in particular are notching above-average growth rates and have strong cash distribution. Importantly, most cyclical and longer-term earnings drivers appear healthy. Enterprise spending is accelerating as companies position for cloud architectures. Internet advertising continues to take share from traditional media platforms. And while end-market penetration of smartphones appears mature, most stocks linked to this market already trade at a valuation discount to the sector. Overall, the global tech sector earnings growth should outstrip the broad market with double-digit percentages this year and next.

While continued rotation into value stocks and market laggards could persist in the near term, given the current stage of the stock market cycle, in which economic growth is broadening out, improving fundamentals for tech companies, on the back of solid product cycles and a lift in enterprise spending, continue to underpin tech's prospects.

The importance of tech to Asian investors is encapsulated by the fact that technology has now replaced financials as the largest sector in the MSCI Asia ex-Japan index, with a weighting reaching 30 per cent in June; for reference, technology claims 22.6 per cent of the S&P 500.

ASIA TECHNOLOGY'S RISE AS GLOBAL LEADER

In Asia, the emergence of technology as the linchpin of Asian equities is perhaps gaining even greater ground than in the rest of the world. The sector's explosion in the region has helped spawn a class of billionaires - three of the top five billionaires in China hail from the technology sector - and around one-third of global tech unicorns (unlisted start-ups valued at more than US$1 billion, or S$1.4 billion) reside in Asia.

The importance of tech to Asian investors is encapsulated by the fact that technology has now replaced financials as the largest sector in the MSCI Asia ex-Japan index, with a weighting reaching 30 per cent in June; for reference, technology claims 22.6 per cent of the S&P 500. The rise of Asia's tech stocks has been driven by concrete fundamentals and bountiful profits - regional profit share is up to 27.5 per cent from 17.5 per cent in 2012. And thanks to Asian consumers' penchant for all things digital, Asian tech firms are steadily gaining market share from traditional rivals in consumer discretionary, financial and telecommunications sectors.

Looking ahead, several segments are poised to profit from the industry's superior growth rates in years to come. First, Chinese Internet companies should continue to benefit from online trends such as e-commerce, online gaming, mobile payments and the sharing economy. Second, the semiconductor and hardware supply chains should benefit from rising consumerisation, riding on trends such as the Internet of Things and big data, electric vehicles and autonomous driving. Third, overarching themes such as the rapid adoption of artificial intelligence (AI) should continue to widen the lead of tech over old-economy firms.

Asian technology firms could likely follow the evolution as platform companies, much like what the US tech giants have done, spreading into multiple segments and adjacencies and benefiting from network effects. A case in point is Chinese Internet firms diversifying into areas such as e-commerce, payments, gaming, advertising and video. The presence of Korean technology firms across consumer electronics, memory, displays and household appliances is another example.

One longer-term risk that puts a cap on Asian prospects relative to US peers is that the monetisation rate in China in areas such as e-commerce, social networking and digital advertising is already well above global averages. The good news is that Chinese Internet firms continue to invest in new areas such as AI and the sharing economy, while cloud computing is a major area where Chinese players could catch up.

Just as the ubiquity and dominance of technology is expected to spread in everyday life, holdings of technology stocks should increasingly become a part of an investor's core investment strategy. Chinese Internet and Korean, Taiwanese and Indian (in that order) technology firms offer the greatest exposure to the structural growth story playing out across Asia. Within these groups, large-cap tech companies and index heavyweights are preferred. Their competitive edge over their smaller peers, including the ability to acquire and retain the best talent, should help generate strong profits and cash flows, which are crucial for further investments in frontier technologies, thus fuelling additional growth.

To be sure, share prices of Asian and US tech firms may be more muted in the very near term, given their already impressive year-to-date gains. Still, they offer solid long-term growth potential and should continue to outperform other sectors in the years to come.

•The writer is the Asia-Pacific regional head at the chief investment office of UBS Wealth Management.

A version of this article appeared in the print edition of The Straits Times on July 03, 2017, with the headline 'Tech still makes Asia tick'. Print Edition | Subscribe