Digital transformation was already underway prior to the COVID-19 pandemic, but the resulting economic crisis has caused an acceleration, according to Franklin Equity Group’s Jonathan Curtis. He shares where his team is looking for potential opportunities within technology during the current period and beyond.
While the global community is still reeling from the uncertainty of a new reality under the COVID-19 pandemic, the tentative economic reboot that appears to be underway in many parts of the world is encouraging to us. However, we still see a number of structural impediments to strong global gross domestic product (GDP) growth, including the severe but potentially short-term impact of COVID-19 in the near term as well as longer-term headwinds such as high levels of debt across major economies, adverse demographics in developed markets, a lack of political will for serious structural reform, and elevated geopolitical and trade risk, just to name a few.
In this environment, we believe investors will place a premium on companies that can grow revenues and earnings—regardless of GDP growth—by addressing secular shifts in the way we interact with friends and family, shop and pay for goods and services, treat our illnesses and spend our leisure time. Overall, we seek to tactically anticipate the ongoing convergence of technology with other sectors which are increasingly tech-adjacent.
As we screen for new ideas and evaluate our current strategy, we continue to focus on identifying what we consider to be the highest-quality businesses (good margins and/or unit economics, strong balance sheets and agile managers) with the best long-term growth prospects trading at attractive valuations. We have also been looking to avoid businesses with (1) high leverage to the most negatively impacted industries; (2) weaker balance sheets; and (3) more challenged free cash flow positions in the current business environment.
Our team remains focused on the big theme of Digital Transformation (DT) and its associated sub-themes of cloud computing, new commerce, fintech and digital payments, data analytics, “edge devices” and the internet of things (IoT), artificial intelligence (AI) and machine learning, information technology (IT) security, collaboration and workflow, and 5G network communications. We believe the COVID-19 crisis is shining a bright light on the growing role of technology in our lives.
Coronavirus-driven imperatives around working from home, educating from home, e-commerce, remote health care, streaming media, contactless delivery and others have all become dramatically more important in 2020, and have accelerated many secular themes we see at the core of the IT and communication services sectors.
DT and its attending themes were going strong in the pre-COVID environment. We believe DT will be an integral part of the pandemic solution during the current crisis and will continue to lead over the long run in a post-COVID world. While near-term demand, margins and free cash flow metrics are highly uncertain for nearly all companies, we believe evidence is mounting that enterprises which invested substantially in their own digital transformations prior to the crisis are now reaping the rewards of those investments and pulling ahead of their competitors.
Specifically, we believe DT leaders are proving that they can more quickly understand the state of their businesses and customer base, respond to their customers’ needs faster than ever, and plot a path forward in what is proving to be a highly dynamic business environment.
Considerations Coming Out of Crisis
Coming out of the crisis, we believe that DT will prove as important as ever and could even accelerate as digital laggards play catch-up while knowledge workers and consumers retain at least some (if not most) of the new technology-led behaviors that became necessary in an era of global social distancing.
We would also note that coming into the crisis, the IT sector offered some of the highest-quality businesses and the best balance sheets across the S&P 500 Index. Specifically, the IT sector was the third most profitable sector in the S&P 500 Index over the past three years (through June) and one of just three net cash-positive sectors, an elite group that also included the communication services sector.1
Following a strong quarter of performance for many technology companies, equity valuations have become a growing concern. The recent climb in valuations across the IT and communication services sectors is causing us a bit of pause; we are looking for opportunities where investors seem less focused. We believe the increase in valuations is being driven by new investors coming into the sector for the structural growth, more stable earnings profile and high-quality businesses that can be found across related industries.
Heading into July, our analysis indicated the IT sector was trading at a 30% premium to its median level over the past three years, while communication services companies were collectively trading at a 16% premium; this is versus the S&P 500 Index, which was trading at just a 5% premium to its median level over the past three years.2
US-China Trade Tensions Add Uncertainty
Other risks we are monitoring include the deteriorating US–China trade situation, for which there seems to be no let-up in tensions. The situation became even more challenged during the spring months as US President Donald Trump’s Administration imposed new licensing restrictions, which is creating incremental challenges for key Chinese suppliers across the semiconductor and semiconductor capital equipment industries (in particular those supplying Huawei and TSMC), as well as for US-based companies looking to sell into the Chinese market.
Regulation is another area we are paying close attention to, in both the United States and European Union, with recent investigations into the business practices of key digital leaders including Alphabet, Amazon, Facebook and Apple. We are also monitoring the impacts the rapidly approaching US presidential election may have on the tech sector, including governmental scrutiny of the largest technology firms. While we are less concerned about potential antitrust-related issues given how the standards for antitrust are interpreted, there could be near-term headline risk.
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1. Source: Bloomberg, through June 2020. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
2. Ibid.
© Franklin Templeton Investments
© Franklin Templeton Investments
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