Disappointment at Netflix’ half-year results this week is evidence of the change of leadership in the technology sector, as smaller companies overtake larger rivals and investors have to look beyond FAANG stocks for growth, says fund group Fidelity.
Technology stocks have continued their run of growth over the past year but picking the big winners is no longer as easy as putting money into US FAANG stocks - Facebook (FB.O), Amazon (AMZN.O), Apple (AAPL.O), Netflix (NFLX.O), and Google (GOOGL.O) - or their Chinese BAT equivalents - Baidu (BIDU.O), Alibaba (BABA.N), and Tencent (o700.HK) stocks.
This was brought into stark relief by Netflix yesterday as shares in the TV streaming service plunged 14% on disappointing second quarter new subscriber figures.
Hyun Ho Sohn, manager of the £2.7 billion Fidelity Funds Global Technology fund, said while 2017 was characterised by mega-cap outperformance, the ‘momentum is now extended to extreme levels’ and technology ‘sector leadership has changed’.
Communications equipment, software and IT services are the best performing sectors in the past 12 months, pushing the large internet names off their perch.
Ho Sohn added that small caps are now outperforming large and mega cap stocks and he remains underweight the latter.
‘There has been increasing dispersion among mega caps, with Amazon continuing to perform strongly, but with Tencent, Alphabet and Facebook weaker,’ he said.
‘Netflix had been on a stellar run in 2018 until [the] second quarter results, which undershot analyst expectations on new subscribers. Facebook has suffered from growing concerns about potential negative effects of regulation.’
There is also intensifying competition within the FAANG and BAT stocks as Google’s Alphabet and Amazon compete for advertising and cloud revenue, while Facebook competes with Alphabet-owned YouTube in video content.
‘Investors are underestimating the likely decline in returns on capital among these companies owing to increasing competition, with rising investment leading to declining returns on invested capital, with increasing regulation also leading to higher compliance costs,’ said Ho Sohn.
The technology sector may be growing at more than double the rate of global GDP but Ho Sohn (pictured) said it remains ‘reasonably priced’ compared to its own history and global equities.
The most expensive stocks were FAANG stocks on one hand and new companies floating on the stock market in initial public offers of new shares (IPOs). Demand for both was stoked by ‘loose liquidity conditions and ongoing low interest rates’, he said.
‘The sector as a whole is displaying increasing quality over time, with superior margins and return on equity relative to global equities,’ said Ho Sohn.
He has increased his position in Oracle Corporation (ORCL.N) after it was ‘oversold due to negative narratives’.
He said the fundamentals of Oracle are ‘much more resilient than consensus gives the company credit for’.
The fund has also opened a new position in PC and mobile-based video games company Nexon (3659.T), which owns games franchises in China and Korea.
‘It is a high margin, cash generative business trading at an attractive valuation – one much cheaper than global gaming peers,’ said Ho Sohn.
Within the semiconductor sector, the fund has benefited from a position in Intel (INTC.O), which is ‘working through security issues with its chips’ and should ‘benefit from growth and margin expansion driven by demand for data centres’.
The fund has a new position in semiconductor equipment company KLA-Tencor (KLAC.O), which Ho Sohn said has a ‘dominant position in metrology and inspection tools’.