What’s been very puzzling for many people observing the coronavirus crisis is just how well technology businesses have generally held up through the ‘corona crisis.’ In this bear market, to this point, technology businesses have been major beneficiaries of a so-called ‘flight to quality.’
This can be seen in the year-to-date performance of the technology-heavy NASDAQ 100 (QQQ), versus the performance of the S&P 500 (SPY). The QQQ is down only 3.65% year to date, versus the S&P 500 which is down almost 14.6%.
Value investors have generally been hoping and expecting that a more pronounced bear market would allow value-based strategies, which have typically underperformed through all phases of the 10-year long bull market to finally catch up. There are likely a number of reasons why technology has outperformed traditional value plays.
Large technology businesses are extremely well-capitalized
The savage selloff in late March and subsequent rebound were characterized by an almost panic situation from many investors. The prospects of businesses across industries, both large and small being forced to the edge, created an environment of genuine fear that many businesses would go under and created a shift towards businesses that were strongly capitalized with high cash balances. While companies like Ford (F), General Motors (GM) and United (UAL) are having to manage through high levels of indebtedness either by seeking government assistance or trying to tap the debt markets, businesses like Google (GOOGL) (NASDAQ:GOOG), Facebook (FB) and Microsoft (MSFT) are extremely well-funded and capitalized with cash balances in the tens or hundreds of billions. The reassurance provided by strong balance sheets has led many investors to seek safety and survival first while they sift through the wreckage of what else may survive. With cash providing negligible returns, this has resulted in a natural flight to quality toward the large technology businesses in particular.
This bear market has the effect of accelerating secular trends
The coronavirus bear market will create real winners and losers and accentuate many of the secular trends that were already taking place in the economy. What’s been very unusual about the bear market to this point is that so-called value names trading at low multiples have actually become cheaper. Macy’s (NYSE:M), for example, was trading at a rather undemanding P/E of only 5.5x trailing earnings prior to the onset of the corona crisis. The business currently trades at under 3x earnings. A similar effect was observable with J. C. Penney (NYSE:JCP) whose Price/Sales ratio has collapsed by 1/3. This can be compared to something like Amazon (NASDAQ:AMZN), whose end of 2019 P/E of 76x earnings has increased to over 100. Why is this?
Amazon, which is incredibly up almost 26% year to date, will no doubt continue to take market share as e-commerce will inevitably grow through and out of the downturn which has seen many brick-and-mortar discretionary retailers and retail malls become short on traffic for an extended period of time. If customer needs can be met in a timely fashion, and the experience of users across categories is a satisfactory one, Amazon will continue to keep and permanently retain these customers, even once things return to a state of new normal. It’s also highly likely that the corona crisis will cement new habits among consumers. What’s particularly exciting the market in the case of Amazon is the acceleration of Amazon’s penetration into new categories, such as grocery. Digital order and delivery of groceries which was an emerging trend through this crisis is likely to have picked up steam and accelerated, as shoppers ditched going in store for groceries to ordering online, allowing Amazon to gain share in a new category.
SaaS is transformative for the resilience of technology businesses
What’s particularly different about many technology businesses in recent times compared to in the years gone by is that most of the large technology businesses have commenced or completed transitions to a Software as a Service (“SaaS”) business model. The implications of this shift are fairly significant in the impact that a reduction in IT spending will have on these businesses. In the past, most technology businesses operated on a perpetual or fixed-term licensing model. This meant that when times got tight, IT departments could simply sit on existing or older versions of software and not spend. However, under a SasS model, enterprises are required to maintain regular payments for the right or access to use the software, with a failure to pay resulting in a loss of use.
Many large technology businesses such as Adobe (ADBE), Microsoft (MSFT) and Salesforce (CRM) have completed the transition to SasS models. They also generally provide mission-critical software. While IT departments may choose to curtail some licenses which aren’t fully utilized, they actually can’t entirely retrench spending as enterprises will be without the content creation tools that Adobe provides or the business productivity software that Microsoft enables or the pipeline management functionality that salespeople rely on with Salesforce. Technology businesses now have an element of durability and revenue consistency that they previously didn’t have, something which investors have caught onto during this crisis.
Traditional safe havens haven’t held up
Some of the ‘low beta’ flight to safety plays that have been traditional safe havens in times gone by have been more exposed to the direct economic impacts of the pandemic than in previous downturns. While many consumer staples safe havens such as Clorox (CLX) and Procter & Gamble (PG) have held up well, generally being flat to only slightly down year to date, other traditional low beta safe havens such as Coca-Cola (KO) and McDonald’s (MCD) are particularly impacted, with Coca-Cola down almost 17% year to date and McDonald’s down almost 10%. While it’s clear that the inability to ‘eat in’ will more disproportionately impact McDonald’s, what’s less obvious is that Coca-Cola has a lot of on-premise channels through food service distribution and onsite vending which accounts for a meaningful proportion of revenues.
In contrast, technology software doesn’t suffer from the challenge of access, even with workers and workforce more distributed. Cloud-based delivery of software ensures continual product availability irrespective of location.
While historically, technology tends to be more adversely impacted by major market sell-offs, the resiliency of the tech sector has been very apparent during this crisis. Large tech business models now have an element of revenue predictability, are cash-rich and have strong cash balances and are able to provide continued product availability irrespective of location.
It’s worth investors reassessing their perspective of technology stocks as volatile and erratic, but rather as having the characteristics of a more durable sector which can prosper throughout economic cycles and something which should persist even post the resolution to this crisis.
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Disclosure: I am/we are long AMZN, GOOG, CRM, ADBE, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.