Technology: Stocks Still Outperformed in Q3, but Returns Are Normalizing

After another historic rise through early June, driven primarily by semiconductor and AI-related stocks, technology sector returns have cooled somewhat. A combination of geopolitical risks such as the Iran war, worries about the size and sustainability of the AI buildout, and what we viewed as some stretched valuations has contributed to this. The Morningstar US Technology Index is up 32.0% on a trailing 12-month basis, compared with 20.0% for the US equity market, with quarter-to-date returns of 5.4% versus 2.0%, respectively.

While some stocks have cooled off, we think the AI buildout remains fundamentally intact. The buildout is still supply-constrained, capex estimates for 2027 have risen, the unit economics on recent compute deals suggest very healthy ROIs for installed compute capacity, and token consumption continues to increase exponentially while model capabilities continue to improve. While we remain positive on the fundamentals, many semis screen as overvalued, so we would be very selective here. Cybersecurity names have run up quite a bit and are overvalued. After the recent partial comeback for software, we see the sector as closer to fairly valued. The remaining pockets of broad subsector undervaluation are now within the hyperscalers and IT Services.

We expect hyperscaler capital expenditures to keep climbing, growing at a 33% CAGR through 2030 and approaching $1 trillion in 2027. Hyperscalers win either way. If AI delivers, they monetize their compute, and if it disappoints, they can cut capex and free cash flow rises anyway. Semiconductor firms lack that cushion, because their revenue falls directly with any slowdown in the buildout. That said, we still like Nvidia and Broadcom, both fundamentally and on valuation, and forecast strong AI chip revenue growth through 2030, as we see the buildout as still being intact.

Top Technology Sector Picks

Broadcom AVGO

• Fair Value Estimate: $650.00
• Morningstar Rating: ★★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

Broadcom remains one of our top picks in semis, and we maintain our $650 fair value estimate after strong fiscal third-quarter results. Management guided to $115 billion in AI chip revenue in fiscal 2027 and $230 billion in 2028, which we see as conservative and limited by supply, not demand. We expect OpenAI and Anthropic to become Broadcom’s two largest customers in 2027, reducing its reliance on Google. Shares have fallen nearly 30% since the prior quarter, and we think they look like a bargain against this growth.

Alphabet GOOG

• Fair Value Estimate: $433.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

Wide-moat Alphabet is one of our top picks, and we think its full-stack AI approach is paying off across segments. Second-quarter sales grew 24% to $120 billion, and Google Cloud grew 82% to $25 billion, with its backlog rising to $514 billion from $108 billion a year ago. Search grew 17% as AI Mode passed 1 billion monthly users. Alphabet’s TPUs give it a lower cost basis than GPU-based rivals and let it profit from AI spending even when customers such as Anthropic use their own models.

Amazon AMZN

• Fair Value Estimate: $300.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

We recently raised our fair value estimate for wide-moat Amazon to $300 from $280 and still see shares as attractive. AWS growth accelerated to 37% in the second quarter, its fastest in 18 quarters, and its backlog more than doubled to $496 billion. AWS remains capacity-constrained for generative AI, with capacity nearly fully subscribed through 2027. Advertising grew 26% to $19.8 billion, and operating margin rose to 13.7% from 11.4% a year ago. We see AWS and advertising as the main drivers of growth and margin expansion.