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3 Undervalued Tech Stocks

Look beyond the tech giants for hidden opportunities.

Technology continued to significantly outperform the broader market as we exit 2020. We still wouldn’t characterize this rise as a bubble across the higher-quality, larger-cap tech names we cover, as we see robust fundamental tailwinds supporting future growth for most of our coverage, such as cloud computing, remote working, 5G network rollouts, and the "Internet of Things." However, valuations for certain names still appear unreasonable to us, and a pullback in tech stocks would likely be healthy, in our view. We struggle to identify many tech stocks trading at attractive valuations today.

As of Dec. 21, the Morningstar US Technology Index was up a whopping 46.8% year to date, vastly outperforming the U.S. equity market, which is up 19.4% year to date. Over the past three months, tech performed relatively in line with the broader market, up 13.6% compared with the U.S. equity market up 12.8%.

Tech outperformed broader market in both the COVID sell-off and rebound - Morningstar

As of Dec. 21, the median U.S. technology stock was 20% overvalued, up from 15% overvalued a quarter ago, and was again one of the frothiest valuations we've seen for the sector since 2007. Hardware is still the cheapest subsector, but at 12% overvalued, it doesn't provide much value. However, the higher-quality names we cover tend to be in semiconductors and software, and we still view these subsectors as overvalued. The median stocks in semis and software are now 22% and 23% overvalued, respectively.

Buying opportunities are rare in technology despite COVID-19 - 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. The best-positioned names for the remote work trend are Zoom Video Communications ZM and DocuSign DOCU, but valuations are rich. Instead, our top pick is wide-moat Microsoft MSFT, thanks to Teams, Connect, and its strategic relationships with so many customers.

Remote working software has the fastest growth but higher multiples - Morningstar

In semiconductor equipment, we see many wide-moat names and reduced cyclicality for the industry, thanks to consolidation of key customers and an increase in end-market diversity beyond PCs and smartphones. The industry should grow at a 6% CAGR long-term. Lam Research LRCX and KLA KLAC are industry leaders, and we would be avid buyers on a pullback.

Chip wafer front end spending should rise at a 6% CAGR through 2024 - Morningstar

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 SaaS-based offerings is well underway and we expect VMware to benefit from customers attempting digital transformations.

Splunk SPLK Star Rating: ★★★★ Economic Moat Rating: Narrow Fair Value Estimate: $208 Fair Value Uncertainty: High

In a highly digitized world, Splunk’s Data-to-Everything platform enables businesses to gather and analyze vast quantities of data (Big Data) generated by complex operations and to derive meaningful insights from it. We believe narrow-moat Splunk faces a strong growth runway, which will also be supported by its pivot toward becoming a cloud-first company. Splunk faced a tough third quarter, but in spite of near-term headwinds, our long-term outlook remains unchanged as we expect Splunk to still be able to execute on its cloud strategy and continue to develop its holistic platform to expand use cases and generate healthy user growth.

Intel INTC Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $65 Fair Value Uncertainty: High

Wide-moat Intel trades at an attractive discount to our fair value estimate of $65 per share. The chip titan's comprehensive product portfolio tailored to computers from the data center to the edge gives us confidence in the firm's long-term growth prospects despite increased competition from Advanced Micro Devices and a recent delay in the rollout of cutting-edge chip manufacturing. We applaud Intel's scattershot approach to address challenges in computing (artificial intelligence and cloud), connectivity (5G), and automotive, while its acquisitions have unlocked new growth vectors outside of its core CPU business.

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