In this episode of our Global Perspectives podcast series, Portfolio Manager Denny Fish joins Adam Hetts in a discussion of how different segments of the tech sector will likely be impacted through each phase of the global economic reopening and recovery.

Key Takeaways

• High-growth tech stocks’ potential for multi-year growth should allow them to withstand near-term pressure caused by rising inflation expectations.
• As we move through various stages of reopening, certain areas of the tech sector stand to benefit, with cyclical growth stocks such as semiconductors being the initial beneficiaries, followed by digital advertising platforms and payment processors as we enter the re-consumption phase.
• We also expect demand for robotics and artificial intelligence to accelerate as more areas of the economy embrace these technologies for process automation.

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Adam Hetts: Welcome to Global Perspectives where we feature candid conversations with Janus Henderson’s thought leaders under host Adam Hetts, Global Head of Portfolio Construction and Strategy here at Janus Henderson. Today I have go the pleasure of hosting Denny Fish. Denny is a Portfolio Manager, a Research Analyst and also leads our technology sector research team. Denny, thanks for being here.

Denny Fish: Yeah, thanks for having me.

Hetts: My pleasure. So as luck has it, equities and especially tech stocks have been going through a bit of a sell off lately, seemingly fueled by inflation concerns. So Denny, can you catch us up on what is going on and why tech seems to be taking the brunt of these inflation worries?

Fish: Yeah, sure. There are several subsectors of technology, so broadly speaking, the part of the tech sector that has been taking the brunt of the selling pressure are what we would describe as those firmly in the growth camp. And that generally relates to businesses such as software or internet related or media businesses, where the business models generally have some common characteristics, and those being they are relatively high growth. They are in investment mode and they tend to be building durable competitive advantages, in many cases through investing aggressively, given where they are at in their life cycle. And so as a result, when you have interest rate pressures – or in this case inflationary signals – that suggest that rates could potentially move higher, then that raises the discount rate, and therefore growth assets generally come under pressure, because you are discounting cashflows from further out in the future. And with the higher discount rate, that can in the short term lead to lower valuations and multiples.

So that is kind of the mechanical aspect of what is going on. The other thing that I would say that is also going on is there are parts of technology that are clear beneficiaries of both a reopening of the physical economy globally – and we will talk more about that later on – areas like semiconductors, for example, which clearly benefit from that. So you also get what I would refer to as rotations within the technology sector toward those sectors that are benefitting materially from the current environment and, you know, I would argue it is no different than what we experienced at the beginning of the pandemic when everything cloud-related really, really served to help keep the global economy afloat. And many of those businesses saw their fundamentals actually accelerate relative to what their growth rates were pre-pandemic. And now we are just kind of seeing the inverse of that. So you combine that with inflation of rates and that can be a short-term recipe for a volatile market for growth equities.

Hetts: So it is not the inflation specifically, but if the inflation concerns lead to higher rates, that is what is maybe putting the pressure on tech. And you look historically when rates were plummeting, tech did really well, but it is hard to disentangle the plummeting rates compared to all the other factors that are working in tech’s favor over the last few years or decades. So as a Portfolio Manager today, do you see that duration risk as a real risk? You said it is mechanical, but then in real life is that really a problem, or is it something that is in the headlines that you sort of roll your eyes about?

Fish: What I will say is if we just rewind the clock and we go back let’s just say to 2015 and we look at what the growth of the broader economy was in the developed world, and we distinguish between the physical economy and the digital economy, by and large, most of the economic earnings, free cashflow, revenue growth came from the digital economy versus the physical economy. And then the pandemic hit. So we kind of had like, this has been in motion for 20 years, you know, [and] really got going after the Global Financial Crisis. And then we really started to see acceleration in kind of the ’15 to 2000 timeframe as we saw these technology companies really kind of balloon in scale, as well as a lot of value being created in small- and mid-cap technology companies. And then the pandemic hit and many of these same companies that had been kind of economic share leaders for multiple years saw the businesses improve meaningfully in a number of cases. And so what happened was there was a ton of enthusiasm for that, so you had both rates come down a lot because of the monetary policy response by the Federal Reserves globally. But at the same time you also saw these businesses where their financial performance was fundamentally stronger than one would have expected when many other companies were actually really, really struggling. So now we are getting, as I mentioned, the inverse of that, where companies that really benefitted from that rate component and the revenue and financial performance acceleration, you know, the businesses are likely to still be very strong in many cases, but not quite as strong as they were on a relative basis last year, and you have rates going up. So as a result, that puts some pressure on some of those areas. And so that is the way I would describe it, a little bit of both.

Hetts: So in a sense then you are concerned about duration, but you are just looking to overcome it by having securities that are better exposed to growth, so they can overwhelm the duration risk.

Fish: Well, that is exactly right, yeah. So we will get through this period and this period will have some transitory effects and those transitory effects are going to be really good for some subsectors, like we mentioned with semis. And then the important part is the stocks in sectors that have true growth optionality and tend to grow meaningfully higher than global GDP will grow into their … you know, their multiples are coming down, and they will grow through that. And then we will look out to 2023, ’24, ’25, and those companies will be meaningfully larger businesses than where they are today.

Hetts: We were focusing a bit on the cyclical grower and semis as an example, but can you broaden that out a little bit and just maybe decompose the sector overall a little bit between what you are seeing as those cyclical growers versus the other ones that might just be getting more of a short-term bump from the general kind of reopening excitement that we have got right now?

Fish: You know, it is interesting and that is why I put in that phrase, “high-quality cyclical growers.” And so areas like semiconductor capital equipment, you know, grade space on the analog semiconductors, leading edge digital semiconductors, these are all areas that are actually completely out of supply and demand imbalance right now. Supply chains were disrupted for a couple of years, first [due to] the Trump-induced trade war that occurred, which put a lot of pressure on semiconductor supply chains and a lot of uncertainty, and then the pandemic. So you had this couple-year period that was really, really difficult. But they are great businesses, they were experiencing some cyclical downward pressure and now they are coming out. There is a lot more demand than there actually is supply and so you have actually seen impacts to supply chains globally where auto lines have had to come down, industrial can’t quite scale as fast as it needs to because of these shortages, and those will ultimately take care of themselves. But it is because they are such critical components to just about everything today to make the world go round.

And then you have another dynamic that is going on in the market right now, with rising rates and coming out of the pandemic, this idea of value factor having some prominence relative to growth for the first time in quite a while, it gives an uplift to a lot of really low-multiple businesses. And so importantly, companies might have a really low earnings or earnings multiple or free cashflow multiple to their enterprise value. But generally speaking, companies that trade at really low multiples in technology have earned that multiple over many years. And whether we are in a reopening phase, which might give a modest uplift to legacy technology providers that have structural challenges in their businesses or industry. PCs are a good example: we have been in one of the most robust PC environments over the last year. Why? Because we went to work from home and a lot more people than normal refresh their PCs and businesses and consumers. Before that we were stuck for almost 10 years at not really being able to grow that part of the market much, because of the proliferation of smartphones, for example, and the extended life of those products. So if you think about it, the PC industry is going to get through this and it will be right back to not growing and people will have just refreshed and it might be seven or eight years before that computer is actually refreshed again. So there are things like that that you have got to be careful on.

Hetts: So in thinking about the next seven or eight years, as we get through this economic recovery and it pushes forward, it seems like statewide is what you mentioned around semis as far as these cyclical growers that will react well as production ramps up and demand for semiconductors goes up. What are the steps after that, as you see the economy recovering gradually, and how does that then fall into other?

Fish: Absolutely. I sort of think about it as first-derivative, cyclical beneficiaries, second-derivative, third-derivative, cyclical growers, with semiconductors being clearly first-derivative beneficiaries. Because for the physical economy to get going, it actually needs digital content, and that is what semiconductors provide. And then you have a couple of phases, and that is this phase of consumers getting back out and doing the things that they want to do. And so that is generally doing more things in your localized area, you know, going out to restaurants again, spending a little less time in front of computers and more time out in the physical economy and leveraging services that way. So what I call that is kind of the first phase of re-consuming in the physical world, and kind of the second and the third come together and that is, you know, the third phase is really getting out and traveling aggressively again on the consumer side, traveling for business, cross-border at some point comes back. And the natural beneficiaries of the uplift and second derivative and third derivative are things like the payment processors. One of the trends that was firmly intact prior to the pandemic was a continual shift from cash to digital payments, debit and credit continuing to grow as a percentage of transaction processing annually. And the pandemic actually in some ways accelerated it, because adoption of things like e-Commerce and food delivery and all those things, grocery and all those things that we did that require some sort of credit card. But at the same time, so much of the activity around dining and travel and everything else put a lot of pressure on those businesses. And so we firmly expect those businesses to continue to get an uplift that should be really sustained.

And then other areas too in the same way that food delivery, for example, through digital services really got an uplift from the pandemic, we will see an equally strong uplift from things like ride sharing again, where consumers are likely to come back to services like that as the physical economy reopens. And so that would be another natural beneficiary. And then online travel, you know, as we continue to travel more, those should be beneficiaries as well in kind of both the second and third camp. And both for consumers to enable selection and search and choice. But then also given the amount of inventory that was created for hotels and operators and independents to be able to efficiently get their inventory source as we come out of this. So those are kind of a number of categories of companies that should continue to benefit as we get through the next phases of the economic recovery.

Hetts: Yeah, thanks. So to recap that a bit, the first derivative or the first stage is sort of the ramp up of production, and that is more of the cyclical growers, semis-type demand. Then you have the re-consumption pickup with the demand for digital advertising platforms and whatnot there. Then the third derivative would be paying for all that consumption and the payments’ processors. And it seemed like this could all happen in parallel to a certain point, but it is not totally sequential. So we have had that production ramp up. As far as this re-consumption and payment for that consumption coming on, how far along into that trade do you think we are? Are we just in a very early inning still or do you feel like there is enough activity in vaccinations at least in the U.S. that we are getting pretty far along in that stage?

Fish: I think in all of the cases that I mentioned, and if we think about digital advertising for a moment, if we think about digital payments for a moment and we think about digital consumption or the use of online platforms for travel, you know, all of those have unique attributes, and that is they were all kind of share gainers of the economy prior to the pandemic. And as we come out of it, they are true enablers of getting economic growth back on track. So if you are a small business that is levered to the physical economy that has really suffered during the pandemic and you are still kind of alive and kicking, one of the first things that you have to do to reopen is start to aggressively advertise. What these companies have figured out is that local advertising is really, really efficient on the social platforms as well as on Alphabet as well with [Google] Maps and things like that. And so that is just a natural extension of what was going on pre-pandemic and now is super helpful and necessary for getting to the other side as we come out of it. And digital payments, you know, equally is kind of accelerating that trend. And then as I mentioned, online services for booking travel and experiences and ride share and kind of all the things that go along with that, you know, the Uber ride to the airport, what you do in real time, the airline ticket or the hotel or whatever other services you are going to use whenever you get to your destination [are] all facilitated by these online platforms. That is the way I would describe it.

Hetts: So Denny, to move into a totally different topic, and just anecdotally hearing or reading about production needing to ramp up so fast with some of the demand picking up with the rebound here, is that some warehouses or industrial companies aren’t able to hire people quick enough, and so there is more talk about workplace, industrial, warehouse, automation and robotics becoming a major secular growth area in the years ahead. Is this something that you have been kind of covering, or what are your thoughts here?

Fish: Yeah, you know, once again this is a theme or an idea that was developing prior to the pandemic. So we have been studying Amazon’s use of what are called Kiva Robots for several years now. We have been studying the use and proliferation of drones, which in their own right are robots. And there are practical use cases across a number of industries. Think about even like solar repair, right, being able to figure out where there are problems in a solar grid by using a drone, and that is something that would have taken someone a lot of time, a lot of energy to actually potentially get to the right answer. So there are kind of a lot of things.

And so to your point, one thing that is happening, you know, this is relatively well publicized, it is harder than it has been in many years to actually hire workers back in a number of areas. Whether that is warehousing, logistics, fulfillment, even the restaurant industry is really struggling. And so that is probably going to lead to adoption of more automation to the extent that it can be done and more efficient types of software and things for managing micro-verticals like that. But robotics is a really big trend. It is also a trend, and people don’t think about this as much, but knowledge workers. There is this idea of robotic process automation, and effectively process mining. What that means is using artificial intelligence, machine learning, computer vision to augment knowledge worker processes to reduce kind of unnecessary and unproductive steps in process workflows. And so we have sort of talked about a software robot, we have talked about in restaurants you can have robots, in kitchens you can have … there are, you know, restaurants here in the Bay Area that have very little staff and everything is pretty much automated from food prep to actually getting the food out of the kiosk, then all the way through to what Amazon is doing with robots and warehousing and automation. And so there are multiple areas of the economy where robots and process automation are really starting to accelerate.

Hetts: Interesting you mentioned that was a focus not even before the pandemic, essentially post-pandemic now is where this is really becoming widespread narrative. And you just mentioned the Bay Area, I did want to ask about that. So at Janus Henderson our biggest offices are here in Denver where I am, and London, but Denny, you are actually over in the San Francisco area and you are a long-time tech investor. So is that just a coincidence or a little bit of cause and effect there? And how does living in the Bay Area affect just your overall investment style and approach in your perspective?

Fish: Yeah, I mean definitely a cause and effect there. You know, I moved here in the mid-’90s and one thing that was important as I started my career actually in software and industry here in the Bay Area anyway, working for Oracle. You know, Oracle, this was during a period of time when Oracle was growing very rapidly, that is what I call the database wars at the time, software database wars. And fortunately they won and I happened to be there. And there were a couple of things that really helped to kind of shape my career as I ended up evolving into investing several years later, was that the power of platform effects in the software business and how misunderstood that can be and how fast companies can grow when they really do start to build out these ecosystems. And that has really helped instruct me as an investor as I think about these growth-related names and how strong of businesses they can be and the growth associated with them. And then the other element of it … I mean look, the world is a bigger place. There is innovation going on everywhere, whether it is in China or Southeast Asia or Latin America or Europe or here in the Bay Area and all these micro-communities around the United States, particularly with the pandemic spreading out. But there is one thing that seems to persist through time and that is, despite the ups and downs, it is the culture around innovation, experimentation, entrepreneurship is, it is just like nothing that I have ever experienced outside of the Bay Area, having lived in multiple places, and the network that one develops after spending a lot of time here is just really, really unique. And I think that is pretty special and I think that will continue to persist despite a pretty high level of decentralization that we have experienced as part of the pandemic as people have learned to work and operate more remotely. But centers of innovation, they tend to persist and really kind of cultivate the next generation of ideas and businesses that we are going to be talking about when we do something like this 10 years from now as we are thinking about what the world looks like in the early 2030s.

Hetts: Yeah, it is great. Hopefully we get a little more centralized than we have been over the last year and I get to see you in person in San Francisco or Denver one of these days again. We covered plenty, I think it was really helpful for me as far as kind of disentangling the role of interest rate risk in the tech sector and then really helpful the way that you sorted out the different kind of segments of technology and how they might fall, the sequence and those derivatives, as you put it, of the economic reopening. So I appreciate you being here. For our listeners, know that as always, the views of Janus Henderson’s investment teams and thought leaders are freely available within the insights section of our websites. We look forward to bringing you more conversations in the near future.

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