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Pullback Reveals Some Bargains in Tech Sector

We expect strong growth for wide-moat software companies.

The technology sector was a strong market outperformer at the beginning of the COVID-19 pandemic and performed on par with the market in 2021. Technology underperformed the market in the first quarter of 2022, with many companies performing far worse than the overall sector. Nonetheless, technology's performance still exceeds the overall U.S. market on a trailing 12-month basis. We're still fond of secular tailwinds associated with cloud computing, 5G, and the "Internet of Things." Thus, we view the technology pullback as healthy and would point investors toward high-quality wide-moat software companies, such as CRM, ServiceNow NOW, and Adobe ADBE, among others.

As of March 25, the Morningstar US Technology Sector Index was up 22% on a TTM basis, outperforming the U.S. equity market, which is up 14%. Over the past quarter, technology underperformed the broader market, down 10% compared with the U.S. equity market's decline of 5%.

Exhibit 1: The gap between tech and the broader market narrowed in Q1, however.

- source: Morningstar

As of March 25, the median U.S. technology stock was 6% undervalued, a sharp reversal from a sector that was overvalued by 6% and 14% one and two quarters ago, respectively. Yet, while the high number of undervalued mid- and small-cap stocks lowered the median valuation, on a market-capitalization basis, overvalued large-cap stocks bring the tech sector into fair value territory.

Software remains the most attractive subsector. High-flying growth stocks from 2020 have crashed, and many now trade well below our fair value estimates. Meanwhile, more mature, higher-quality software stocks have also sold off and now provide investors with an attractive margin of safety. Many semiconductor firms are also undervalued, while hardware is fairly valued.

Exhibit 2: We see buying opportunities in software and semiconductors.

- source: Morningstar

In software, IT departments have been focused on digital transformation, first from the secular shift to cloud computing and software as a service, followed by the coronavirus pandemic and the critical rush to implement remote working tools. We foresee enterprises using software to modernize all types of business processes, in turn leading to software industry growth at a low-double-digit CAGR.

Exhibit 3: The cloud opportunity is the most obvious secular theme in software.

- source: Morningstar

Additionally, we see an ongoing data boom that not only bodes well for cloud computing, but also database management systems. Traditional databases like Oracle's ORCL still have their place, but emerging beneficiaries will be companies with premier data-lake, data-warehouse, and data-marketplace offerings, such as Snowflake SNOW and MongoDB MDB.

Exhibit 4: The explosion of data, including DBMS revenue, should not slow down.

- source: Morningstar

Top Picks CRM Star Rating: ★★★★★ Economic Moat Rating: Wide Fair Value Estimate: $320 Fair Value Uncertainty: Medium

We believe represents one of best long-term growth stories in large-cap software because of its ever-expanding portfolio of complementary solutions that allow users to completely embrace their customers, thereby building relationships, strengthening retention, and driving revenue. 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 deals for Slack and Tableau.

ServiceNow NOW Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $700 Fair Value Uncertainty: Medium

ServiceNow excels at executing the land-and-expand strategy, and it continues to use its strength in workflow automation to penetrate existing customers more deeply in IT and more broadly with HR, customer-service-specific, and other back-office products. We expect both tiered offerings and vertical-specific versions to continue to provide a nice tailwind to revenue. We think ServiceNow has become a key partner in digital transformation, as shown in retention statistics, which remain at the elite level. We are impressed with ServiceNow's excellent balance between strong and highly visible revenue growth and robust and expanding margins.

ASML Holding ASML Star Rating: ★★★★ Economic Moat Rating: Wide Fair Value Estimate: $800 Fair Value Uncertainty: Medium

ASML is one of our top semiconductor picks thanks to the increasing adoption of extreme ultraviolet lithography at large chipmakers such as TSMC and Intel to support explosive chip demand. Although the firm's first-quarter outlook is negatively affected by supply chain constraints, we think ASML will outgrow the wafer fab equipment industry in 2022 (20% revenue growth versus 15% for WFE). With TSMC, Intel, and Samsung all vying for process technology leadership, we expect ASML to be a primary beneficiary because it sells tools to all three chipmakers.

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