Lim Hui Jie Published on Thu, Oct 07, 2021
US tech stocks are taking a breather, and given how the sector is still trading at record levels, there is a growing chorus that valuations are stretched and that a significant correction is due.
Hou Wey Fook, DBS’s chief investment officer, does not buy that argument. Rather, he sees that current valuations are now at a more “reasonable level”.
Speaking at a briefing for DBS’s 4Q2021 investment outlook, Hou feels upbeat about the US tech sector from another perspective: the staying power of the leading tech names like Microsoft Corp, Facebook, Amazon, Apple and Alphabet (parent company of Google). He observes that these businesses tend to be “asset-light, and most of them, very scalable”. This allows them to generate very high-profit margins.
For example, a PhillipCapital note on Sept 27 pointed out that Facebook recorded net margins of 34% in FY2020 — slightly below its five-year average of 35%.
Its largest cost item is R&D at 21% of revenue, and free cash flow (FCF) has been growing at a CAGR of 14% over the past three years despite its huge capital expenditure programmes.
“Now I’m fully cognisant of the folly in saying that this time is different. But our investment approach is to focus on fundamentals, and the fundamentals [of tech companies are] reaffirming their superiority in their earnings trajectory visibly,” Hou says.
The optimism about the tech sector is underpinned also by the projected surge in capital expenditure across the various major segments.
Strategist Yeang Cheng Ling notes in DBS’s 4Q2021 CIO investment outlook report that global capex in technology has reached 18% of the total last year, up from 12% in 2008.
“We expect its share to grow even higher as nations pivot towards deploying large amounts of capex spend for homegrown technologies, as they aspire to be self-sufficient.”
Various countries, such as China, have announced hefty R&D commitments for a multi-year push. For example, China last year spent US$33 billion ($44.28 billion) in the semiconductor industry, 12 times the amount spent 10 years ago.
“In the race to raise its semiconductor self-sufficiency ratio, we see no let-up in China’s commitment to allocate a substantial portion of its national expenditure to R&D,” notes Yeang.
The US, obviously fully intent on keeping its lead, has allocated US$250 billion to R&D, out of which US$52 billion is designated for semiconductor research, design, and manufacturing. “As a result of these developments, we see a sustained uptrend in technology capex spend, as already evidenced in the annual expenditure of integrated device manufacturers (IDM), logic and memory foundries,” notes Yeang.
The whole semiconductor industry is now bustling with activity, as the likes of Taiwan Semiconductor Manufacturing Co, Samsung Electronics, Intel Corp, Micron and SK Hynix have all announced multi-billion spending plans.
“Evidently, the pandemic did not derail the upward trend in capex spend among the world’s leading semiconductor equipment makers. Instead, we see a spike as the world forges ahead into digitalisation. And we expect this to continue from the tailwinds of old economy industries moving towards digitalisation,” notes Yeang.
Another big growth area is in industrial automation, marked by wider use of autonomous robots. Yeang, citing a study by Robo Global, notes that the base of industrial robots installed worldwide will exceed 3.2 million units by 2021, doubling from 2015.
In tandem, the total addressable market of autonomous robots is projected to reach US$41 billion by 2024.
Other notable growth sectors include artificial intelligence and 5G next-generation mobile communications.
According to Yeang, the spending on 5G has just started — even though the equipment vendors have already been drumming up interest and promoting awareness for years.
Singtel, for example, on Oct 1 announced the partial sale of its mobile towers in Australia, so that it can channel part of the net proceeds of some A$1.9 billion ($1.86 billion) to speed up deployment of 5G networks. “After years of scrimping on investment and capacity spend, telco operators are now raising their capex for the 5G rollout,” notes Yeang.
China in for the long haul
While the US tech sector is buoyant and same goes from the global perspective, China’s hitherto fast-growing industries are facing some near-term challenges.
As news coming out of China over the past month has shown, the tech, education, and property industries are taking a beating because of tightening regulations.
On the technology front, data from Bloomberg showed that the Hang Seng Tech Index has seen HKD$7 trillion ($1.2 trillion) wiped out from its combined market value since its February peak, even entering into bear market territory in August.
This is as regulators enacted moves like limiting online gaming durations on Tencent’s platforms, pulling Didi Chuxing’s apps off Chinese app stores after its IPO in New York, and announcing plans to break up Alipay, owned by Ant Group, which is in turn affiliated to Alibaba.
Hou says that given this highly volatile environment, “it is not uncommon to hear and to read of global investors throwing in the towel, saying China is no longer an investable market”.
However, he begs to differ. Hou points out that a 30% to 40% fall in the Chinese market “every few years is not uncommon”.
But Chinese markets have rebounded and reached new highs after that, he highlights. This is because fundamentals in the Chinese market have not changed, he says, and the country is still on track for around 6% annual growth going forward.
The dip in Chinese stocks can be mostly attributed to the Chinese economic reform agenda, with the goal of “common prosperity”.
Hou looks at it this way: “The approach is really to create more inclusive growth.” He is optimistic about the longterm trajectory of this plan and says: “Spreading wealth to a wider spectrum of the population will lead to a more sustainable and longer-term growth trajectory. In fact, one could say that China is embracing the ‘S’ or the social aspect of ESG, a criterion that has become increasingly mainstream in the world of investing.”
This is in contrast to the US market, where a handful of companies dominate the areas of cloud computing, e-commerce, app stores, and online advertising.
He does acknowledge though, that while this seems tempting for investors to bottom fish at these bargain levels, DBS’s view is that they will “await adding positions in Chinese Internet and tech stocks, notwithstanding the attractive valuations”.
Investors also were hit with another round of bad news in September after Chinese real estate giant Evergrande missed two bond interest payment deadlines on Sept 23 and 29, totaling US$131 million.
A default will occur if these payments are not made in 30 days from the due date. The company is facing about US$300 billion of debt, having borrowed heavily to finance its various projects.
Over the last few weeks, it has warned investors of cash flow issues, saying that it could default if it is unable to raise money quickly.
CNN reported that some analysts fear it could even turn into China’s Lehman Brothers —referring to the company that sparked the 2008 global financial crisis (GFC) — given that real estate and related industries account for as much as 30% of Chinese GDP.
Hou does not think so. He says that although Evergrande is a large borrower in China, he believes the likely default event will be manageable. “It is localised, and it will not trigger contagion across world markets as Lehman’s collapse did.”
This is because China today comprises some 3% of the world equity market capitalisation, and investors are already positioned defensively on the Chinese equity market. In addition, unlike what happened in 2008, Hou does not observe the pervasiveness of highly leveraged structures, like collateralised debt obligations (CDOs), which was seen in the lead-up to the 2008 GFC.
As Evergrande is not a financial institution, he thinks that systemic counterparty risk on the global financial system will be minimal.
For investors now, he advises looking to sectors that are not hit by regulatory changes, like large Chinese banks and China A-shares. “We continue to favour Chinese large banks for the 5% to 6% dividend yield, which we believe is sustainable for the long run,” he says.
This is given their conservative payout ratio of 30%, compared to the 50% payout from regional or global banks. Hou also favours the Shanghai Asian market, which “comprise traditional companies that ultimately will ride on the long term positive fundamentals of the Chinese economy”.
Given all these, what should investors do? DBS recommends that they “stay the course” and remain invested in what it calls its “barbell strategy”, where investors are putting their money to income generators, such as high-yield bonds on one end, and secular growth equities on the other.
For income-generating bonds, DBS states in its report that investors should look at a diversified pool of BBB/BB-rated credits, targeting a portfolio duration of five to seven years, noting that Asia High Yield bonds offer compelling value as record yield spreads overstate its expected rate of default.
On the growth front, the bank remains invested in its direction of investing in companies that are riding the secular wave of long-term, irreversible growth trends, terming these as innovators, disruptors, enablers, and adaptors, or IDEA companies, for short.
This was emphasised in its July 2021 CIO Vantage Point report, which identifies 20 industries that will be dominant in the coming decade. These 20 industries encompass well-known services like cybersecurity, blockchain and the Internet of Things, but also hardware industries like semiconductors, life sciences and 3D printing.
DBS is of the view that strategic national interests for “technological self-sufficiency” will lead to a sustained uptrend in tech capex.
Hou says it is clear the pandemic has exposed national strategic vulnerabilities, due to the disruptions in the global supply chain, especially for IC chips, batteries and medical supplies.
As such, this has pushed governments to get closer to being self-sufficient. “Self-sufficiency will spur a multi-year capex spending in technology. The beneficiaries, of course, will be IC design, manufacturing semiconductor equipment companies, and we will continue to hold outsized positions in them in our portfolio,” Hou says.