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Quarter-End Insights

Strong Tailwinds for Tech in Cloud, 5G, and 'Internet of Things'

Large-cap software has some margin of safety.

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2020 was a banner year for the technology sector, as it outperformed the broader market both during the COVID-19-related downturn and the subsequent recovery. However, tech's outperformance reversed in 2021, and the sector now only modestly outperformed the broader market over the past 12 months. Across most of tech, we still see robust fundamental tailwinds supporting future growth in areas such as cloud computing, 5G, and the "Internet of Things." For most stocks, we characterize the pullback as healthy and still see some stocks with moderately attractive margins of safety for investors, mostly in large-cap software.

Tech outperforming the market, but the gap is narrowing. - source: Morningstar

As of June 25, the Morningstar US Technology Index was still up 44.5% on a trailing 12-month basis, only modestly outperforming the U.S. equity market, which is up 43.9%. Just six months ago, however, this disparity was massive, with tech up 43% in 2020 versus 18% for the broader market. Over the past three months, tech outperformed the broader market, up 9.43% compared with 8.1% for the U.S. equity market.

The median U.S. technology stock is 8% overvalued compared with 10% overvalued a quarter ago. Hardware is the least attractive subsector to us, as it is overvalued by 15%. Semiconductors and software are the relatively most attractive subsectors, overvalued by only 7% and 8%, respectively.

Buying opportunities are hard to come by in technology. - source: Morningstar

Independent of valuation, we remain especially fond of moaty software businesses, as these firms generate revenue on a subscription basis, with little risk of cancellations, even as work shifts to homes and away from the office. Valuations are rich among high-flying remote working software names. We see modest margins of safety in wide-moat, large-cap names like Microsoft, Salesforce, and ServiceNow.

The explosion of data should not be slowing down. - source: Morningstar

In networking, the explosion of data should not be slowing down. We think this bodes well for firms with cloud computing exposure like Microsoft, but we also think that hybrid clouds will be the most prominent form of computing. Companies with exposure to both cloud and on-premises networking, such as VMware and Cisco, will not be left behind, in our view.

Top Picks

VMware (VMW)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $202
Fair Value Uncertainty: High

We believe that VMware has developed an enviable position by becoming the commonality between clouds, including the hyperscale cloud providers, and on-premises environments. The integration of container management within its tried-and-true virtualization platform can give enterprises one solution for application and infrastructure teams, and we expect increased cross- and upselling to come from VMware’s robust security portfolio. The firm’s migration toward subscription- and software-as-a-service-based offerings is well underway, and we expect VMware to benefit from customers attempting digital transformations.

Advanced Micro Devices (AMD)
Star Rating: ★★★★
Economic Moat Rating: Narrow
Fair Value Estimate: $101
Fair Value Uncertainty: High

Advanced Micro Devices' turnaround in recent years has been remarkable, and we believe the firm is poised for sustained success. AMD has exhibited strong execution in innovative chip designs, while Intel's manufacturing struggles have allowed AMD's chief foundry partner TSMC to leapfrog Intel in process technology. We now assign a narrow moat rating to AMD for the intangible assets related to the company's x86 license and chip design expertise. AMD is well positioned to maintain its recent momentum of excess returns, in our view, and we think the market is underestimating its opportunities in PC and server CPUs. (CRM)
Star Rating: ★★★★
Economic Moat Rating: Wide
Fair Value Estimate: $273
Fair Value Uncertainty: Medium

We believe represents one of best long-term growth stories in software. In our view, Salesforce will benefit further from natural cross-selling among its clouds, upselling more robust features within product lines, pricing actions, international growth, and continued acquisitions, such as the recent Tableau deal and the pending Slack deal. Salesforce is widely considered a leader in each of its served markets, which is attractive on its own, but the tight integration among the solutions and the natural fit they have with one another make for a powerful value proposition, in our opinion.

Brian Colello does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.