Ben Hobson via interactive investor

4 months ago6 mins

10 Momentum Plays In The UK Technology Sector

10 Momentum Plays In The UK Technology Sector

Ben Hobson via interactive investor

4 months ago6 mins

10 Momentum Plays In The UK Technology Sector

After more than a decade leading US markets to higher highs, ‘big tech’ suffered some brutal lows in 2022. Savage pull-backs in some of the world’s largest stocks showed how investors had become wary of paying racy prices for the promise of future growth.

Inflation, rising rates and economic pressures led to a weaker earnings outlook for tech firms. Those with models reliant on advertising revenues and buoyant consumer spending were the hardest hit.

In the bloodbath, Tesla stock fell by 65%, Meta fell by 64.2%, Nvidia fell by 50.3%, Amazon fell by 49.6%, Alphabet fell by 38.7%, Microsoft fell by 28.7% and even fell by 26.8%.

Given that these companies were previously valued at hundreds of billions (and even trillions) of dollars, their faltering fortunes had a large relative impact on the market.

These charts (below) from Schroders show how the ‘big 7’ tech stocks in the US led the market higher in 2020-21, then lower in 2022 and are once again outperforming in 2023:

Past performance is not a guide to future performance.
Past performance is not a guide to future performance.

Is the tech sector becoming more investor friendly?

Some commentators think last year was a watershed moment for larger shares in the tech sector. After years of having cheap money available to fund lavish projects in the name of growth, there’s a sense that some firms are (or should be) maturing. In the face of tougher conditions, investors are becoming much more interested in efficiency, profitability, and positive cash flows - and, whisper it, even dividends.

Here in the UK, the tech sector is a much smaller part of the overall market. At the larger end, there are around 10 firms in the £1-10 billion bracket. A couple of them qualify for the FTSE 100, with most of the largest companies found in the FTSE 250. In terms of numbers, the bulk of the sector sits in the Alternative Investment Market (AIM).

Despite having different dynamics to the US, UK quoted tech shares saw similar trends last year, with most stocks suffering double-digit price declines. And while many are still in negative territory on a one-year basis, there are signs that some in the sector are capturing investor imagination.

This week I have taken a snapshot of the tech sector with a focus on the strongest price performances in the first five months of 2023. The results are limited to stocks with a market cap of more than £100 million, which strips out most of the speculative and unprofitable plays.

With one exception, IQGeo Group, I have included rules that look for positive forecast earnings growth, positive return on capital employed, and positive operating margins, as clues to firms that are profitable and have established businesses. The table also shows the forecast price-to-earnings ratios of these shares.

Data: SharePad
Data: SharePad

IQGeo is an exception because it wasn’t profitable last year, so has a negative Return on Capital Employed (ROCE) and operating margin. However, it is interesting to include because it is forecast to see its earnings grow and turn positive this year, which means it does have a forecast price/earnings (PE) ratio. You can see that at 50x forecast earnings, and a strong price trend year-to-date, investors are willing to pay up for slightly more speculative growth in small tech shares like this.

That said, the rest of the list largely tallies with the argument that the market is preferring larger, more profitable firms perhaps with more modest growth expectations, and coming with more moderate valuations. That doesn’t mean they are all fairly priced, but neither are there widespread sky-high PE ratios in evidence.

Some of the biggest UK-quoted tech names have seen strong moves this year, including Moneysupermarket.com, Bytes Technology Group, Auto Trader, Sage Group, and Darktrace. Darktrace is showing a quadruple-digit EPS growth expectation this year as it finally shifts from loss-making to profitability.

Other observations from the results are the strong operating margins that are generated by Auto Trader and Baltic Classifieds Group – 69.5% and 75.6% respectively. Both firms make money using a model of online classifieds, which can be a very low-cost, high profit business.

Another point is the strong earnings per share (EPS) growth forecast at Sage, the accounting software group. Sage is the largest company here, with a market cap of £8.8 billion. Its EPS came in at 25.5p in 2022 and is set to grow by 20% to 30.7p in 2023, which again shows that size is no hindrance in this sector when it comes to delivering strong profit growth.

A sector to watch in a recovery

UK technology shares don’t have the same huge influence on the market as their peers in the US do. However, their performance last year was similar, with even profitable firms seeing their prices fall sharply on gloomy economic news. This side of the Atlantic, many larger-cap tech stocks are in rally mode and beginning to recover lost ground or even break out to new highs.

Frustratingly slow progress on reducing inflation may cause investors to remain cautious on the sector. But if momentum in prices continues to build, it could spread further into the smaller-cap tech shares - making it a sector to watch as the outlook starts to improve.

These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

Disclosure

We use a combination of fundamental and technical analysis in forming our view as to the valuation and prospects of an investment. Where relevant we have set out those particular matters we think are important in the above article, but further detail can be found here.

Please note that our article on this investment should not be considered to be a regular publication.

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