Stretched valuations, coupled with rising interest rates, have landed a one-two punch on technology stocks to start the year.
After a long stretch of technology stock outperformance, these two factors have sent the popular sector into a downward spiral. The Technology Select Sector SPDR Fund XLK is down 11.8% since its peak hit on Jan. 3.
The fear of rising interest rates that triggered a plunge in technology stocks may be slowing just as several companies now look undervalued.
Growth stocks have sold off across the board thus far this year as the markets contend with a new set of dynamics. In our 2022 U.S. equity market outlook, we noted that the tailwinds that had helped propel stocks higher last year have switched direction and are now headwinds to further growth. In addition, we cautioned investors that, according to a composite of the stocks under our coverage, we calculated that the markets were overvalued coming into the year. In particular, we identified that across our sector coverage, the technology sector was one of the most overvalued sectors.
Over the past few weeks, stocks have sold off as investors incorporate the following dynamics into their projections:
- Slowing economic growth rate in the United States
- Tightening monetary policy from the Federal Reserve
- Rising inflation rate
- Rising interest rates
The bulk of the sell-off has been a combination of pricing in slowing economic growth and rising interest rates. Growth and many technology stocks have been hit especially hard because of the long duration of their earnings. A significant part of the value of technology stocks is their future earnings profile, and as investors lower their growth expectations and/or discount those future earnings at a higher rate, the present value for these stocks falls further and faster than the broader market. In addition, market sentiment has turned negative on growth stocks, especially after Netflix NFLX fell off a cliff, dropping over 20% in one day following its earnings release last week.
Following Sell-Off, Here Are Tech Stocks We Find Undervalued Now
The stocks we would highlight for investors today are those high-quality companies that we rate with a Morningstar Economic Moat Rating of wide, or those with long-term competitive advantages. In addition, we are currently focusing on those that have strong pricing power and are able to pass along their own cost increases to customers in order to maintain their own margins. In this market environment, we prefer those companies with both stable cash flows and good near-term visibility into their earnings for this year, yet still have good prospects for long-term growth and large tangible addressable markets.
A few of the more undervalued technology stocks that fit the profile in this market environment include:
We also see value in technology stocks that are leveraged to continued economic normalization in the U.S. For example, as consumer behavior reverts back toward prepandemic habits, we highlight:
In addition, many stocks that fit the definition of “disruptive technology” have fallen to levels that we think are appealing for long-term investors. While many of these stocks were significantly overvalued a year ago and rated with 1 or 2 stars, after dropping 50%-plus, a number of them have fallen to levels that we think are now undervalued. Examples include:
However, investors must still avoid those technology stocks that are pricing in too much growth for too far into the future. Even after this sell-off, these are a few of the stocks that we consider to be significantly overvalued:
It’s Not as Bad as the Headlines Proclaim
Yet, while the markets have been brutalized during the past few trading sessions, the outlook is not as dire as the market action portends. Even with the growth rate slowing, we are forecasting real U.S. economic gross domestic product growth of 3.9% this year and 3.5% in 2023. Similarly, while inflation is running hot and will remain elevated for the next few months, we project it will begin to moderate in the second half of this year and continue to decline in 2023. Finally, as interest rates are set to increase, it should be remembered that they are coming off levels that were not that far from historical lows.
As proponents of a long-term investing strategy, we do not try to time the market but look to identify undervalued opportunities for investors where the markets are not properly discounting the long-term value of a company. Following the widespread sell-off thus far this year, we see a number of stocks within the technology sector that have been pushed down too far during this market rout and provide good opportunities for investors today.
Editor's Note: This version of the article has been corrected with new "Undervalued Technology Stocks" and "Technology Stocks to Avoid" tables.