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Tech Pullback Reveals Some Attractive Opportunities

Software is the most appealing subsector.

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 started to reverse in the first quarter of 2021. Across most of the sector, robust fundamental tailwinds still support future growth in areas such as cloud computing, 5G, and the "Internet of Things." For most stocks, we characterize the pullback as rather healthy, and we’re starting to see some with moderately attractive margins of safety for investors, mostly in large-cap software. In some cases (especially remote working stocks), however, valuations have pulled back a bit further but are still very overvalued, in our eyes.

As of March 26, the Morningstar US Technology Index was still up 67.6% on a trailing 12-month basis, outperforming the U.S. equity market, which is up 58.4% on a TTM basis. Over the past three months, tech underperformed the broader market, up only 1.62% compared with 5.98% for the U.S. equity market.

The gap between tech and the broader market is narrowing, however - source: Morningstar

As of March 26, the median U.S. technology stock was 13% overvalued compared with 19% a quarter ago. In a reversal from last quarter, hardware is now the most expensive subsector, overvalued by 18%. Software is the most attractive subsector, overvalued by only 8%. Semis are 17% overvalued.

Buying opportunities are hard to come by in technology - source: 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, although our estimates might be conservative in the near term as the industry is facing supply shortages. We'd be avid buyers of industry leaders Lam Research LRCX and KLA KLAC on a pullback.

Chip wafer front end spending should rise at a 6% CAGR through 2024 - 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 MSFT, 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 VMW and Cisco Systems CSCO, will not be left behind, in our view.

The explosion of data should not be slowing down - source: 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 up-selling to come from VMware’s robust security portfolio. The firm’s migration toward subscription and software-as-a-service 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: $212 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 to 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. CRM Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $265 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 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.

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