This MD Blog post was written in collaboration with my colleague Mark Fairbairn, Assistant Vice President with the Investment Management and Strategy team here at MD.
Earlier in the year, up to 87 million Facebook users had their data harvested by third party company Cambridge Analytica. It was reported that the firm used the data to develop psychographic profiles to deliver content aimed at influencing voters in the 2016 U.S. presidential election.
It was certainly interesting to watch the so-called scandal unfold. If your social circle is anything like ours, you probably found varied reactions, from resigned to outraged. Some feel that nothing we post online is ever truly private, so why should we be surprised? Others vowed to leave Facebook and other social media platforms forever.
On the investment side, Facebook stock fell nearly 10% after the news broke. We believed this would be a temporary setback and made no significant changes to our U.S. positioning in the information technology (IT) sector. The data scandal didn’t put off investors for long. By the end of April, Facebook released strong quarterly earnings, and the stock recouped about half of its losses.
Strong earnings growth commands a premium
In the U.S., the IT sector is now the largest sector in the S&P 500 Index thanks to its strong growth profile. Earnings growth for IT firms is expected to continue to outpace all other sectors, which should translate into strong earnings per share growth. In today’s low-growth, low-inflation environment, investors have shown that they’re willing to look past issues like the Facebook situation and continue to pay a premium.
Software companies like Salesforce.com currently command the highest premiums, while technology hardware companies such as Apple are trading at much lower multiples. We agree with these premiums, which is reflected in our positioning. In the MDPIM US Equity Pool and the MD American Growth Fund, our largest IT exposure is to software, including positions in Microsoft, Oracle and Salesforce.com, while our smallest weighting is in hardware, where our only exposure is Apple.
Looking ahead, we believe artificial intelligence (AI) and big data will be prominent themes in the sector. Beyond the direct players developing AI, these sub-industries will create higher demand for cloud-based data centres, benefiting core holdings such as Amazon and Alphabet (Google), which provide cloud-computing power. In addition, chip-set companies, like Nvidia, stand to benefit from increased demand for computing power.
China-U.S. trade tensions
While U.S. companies largely bounced back from the fallout surrounding Facebook’s data breach, IT firms in the emerging markets are dealing with ongoing trade rhetoric between the U.S. and China.
In early May, the Trump administration said it was limiting sales of telecommunications equipment from Chinese firms, citing national security concerns, and China spoke of retaliation. Not long after that, President Trump surprised markets by tweeting that he was working with China to save U.S.-sanctioned IT firm ZTE Corp. Most recently, he was quoted as saying that he doubts trade negotiations with China will succeed. If you’re confused by all of this, you’re probably not alone.
For now, we’re comfortable with our positioning in Chinese IT companies, as these tech leaders continue to show strong growth and return on capital. But we’ll be keeping a close eye on Beijing-Washington relations. At this time, we maintain an overweight IT sector position in the MDPIM International Equity Pool and the MD International Growth Fund.
It’s interesting to note some of the China related challenges faced by U.S. based Qualcomm, previously paying US$975 million to resolve an antitrust dispute. More recently, the company has struggled to get Chinese regulators to approve its acquisition of NXP Semiconductors, which some believe is partly due to trade tensions between the two countries.
We have seen a proliferation of IT companies in emerging markets. Of the 20 largest IT firms in the world, five are based in emerging countries including two from China (Tencent and Alibaba) and one each in Korea (Samsung), Taiwan (Taiwan Semiconductor Manufacturing Company) and India (Tata Consultancy Services). Although the geography of the global IT sector is changing, some regions remain much less tech heavy. Europe, for example, has only one firm (SAP) among the top 20. Similarly, Canada hasn’t had a tech company in the top 20 since Research in Motion was on the list back in 2008. Accordingly, our IT holdings are primarily located within the U.S. and emerging markets.
That said, the composition of the top 20 IT names at five-year intervals from 2003 through to 2018 shows little consistency. This doesn’t mean investors should be wary of the sector, but it does mean the companies, sub-industries and regions that are on top today may not be in five years. For the IT sector, it is pivotal for asset managers to actively manage the stock selection and identify themes that will drive the sector forward (such as AI and big data) and determine the winners (and losers) of tomorrow.
So, while unauthorized data usage at Facebook has conjured mixed emotions among users and China-U.S. trade talks continue to see-saw, the investment impact has been limited so far, as growth hungry investors continue to demonstrate an appetite for the IT sector. We’ll continue to monitor this rapidly changing sector to ensure the best outcome for our investment portfolios.
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