investing in technology / ismagilov

This article appears in the February 2022 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

The technology sector has sustained sharp losses in recent months. In part, this reflects the less favourable outlook for growth stocks. Tech stocks have thrived in a low interest-rate environment. But now that interest rates are almost certainly heading higher, the present value of tech stocks’ future cash flow is being discounted by the market.

At one end of the tech-stock spectrum are some of the world’s largest and most profitable companies. At the other are up-and-comers with future prospects, but little or no earnings currently. The latter group is more vulnerable to higher interest rates.

Drawing an analogy between these types of tech stocks and long-duration bonds is Andrew Opdyke, senior economist with Illinois-based First Trust Portfolios LP, an affiliate of Toronto-based ETF provider FT Portfolios Canada Co. Rising rates result in falling prices for both types of securities.

Opdyke favours well-established technology companies that are currently profitable, as opposed to “mid- and long-duration” equities with earnings that may be three, five or 10 years in the future.

“We hope that the growth is going to be there. We expect some growth is going to be there,” Opdyke said at a First Trust conference in Toronto in mid-December. “But if interest rates rise and the discount rate rises, we think that [tech stocks’] valuations are going to see some significant headwinds in the year ahead.”

Despite the recent market shift away from growth stocks, the secular trend favouring technology remains intact. According to Jonathan Curtis, senior vice-president and portfolio manager with Franklin Equity Group in San Mateo, Calif., the Covid-19 pandemic has accelerated the “digital transformation opportunity” for investors: “Growth will be robust for many years for many companies as businesses and their customers seek to build upon the new digital skills they acquired during the crisis.”

IT companies have traded at a premium to broad equities indexes over the past 30 years, Curtis said. The Franklin team still believes that a premium is warranted “given the strong and secular growth in the sector.” A growing number of these companies, he added, have recurring revenue sources, strong balance sheets and strong overall EBITDA (earnings before interest, taxation, depreciation and amortization) margins.

The simplest way to participate significantly in the world’s leading tech companies is through diversified equities investments such as ETFs or mutual funds that track broad market indexes. IT is by far the largest sector of the MSCI world index of developed markets’ stocks, at 23%.

In the U.S., the sector constitutes an even higher 29% of the market capitalization of the S&P 500 composite index. In the Nasdaq 100 index, IT holds a commanding 51% sector weighting.

The same story applies for individual stocks. The world’s most valuable company is Apple Inc., and the second biggest is Microsoft Corp. The tech sector doesn’t even include mega-cap companies such as Meta Platforms Inc. (formerly Facebook Inc.) and Alphabet Inc. (Google’s parent) — both are classified as communications companies — and online retailer Inc., which is classified as consumer discretionary.

Despite the rise of technology, the Canadian market remains dominated by the financial and natural resources sectors, with technology constituting only about 11% of the S&P/TSX composite index. And Shopify Inc.’s recent stock price decline means it’s no longer the most valuable Canadian company.

For Canadian investors who want to increase their technology exposure, there are several options:

  • Direct holdings of stocks. Canada is home to tech companies ranging from Shopify, Constellation Software Inc. and CGI Inc. to the latest micro-cap initial public offerings. But, by far, most of the world’s technology stocks are domiciled south of the border and trade on U.S. exchanges in U.S. dollars.
  • Canadian depositary receipts. For clients who want to own U.S. stocks while avoiding U.S. currency exposure, direct-stock substitutes are available in the form of currency-hedged Canadian depositary receipts. CDRs, sponsored by CIBC and first offered last summer, trade in Canadian dollars and provide fractional exposure to underlying U.S. stocks. As of Feb. 1, 23 CDRs were trading on the NEO Exchange, including the largest technology names.
  • Mutual funds. Surprisingly, the fund-measurement industry doesn’t have a technology category, as it does for energy, precious metals and real estate. Instead, tech mutual funds — as well as ETFs — are in a catch-all category called “sector equity.” Nonetheless, technology mutual funds have been very rewarding for long-term investors. For example, the Fidelity Technology Innovators Fund, the RBC Global Technology Fund and the TD Science & Technology Fund all have average 10-year returns of about 20% as of Jan 31.
  • ETFs. Although most tech-themed ETFs are newer than their mutual fund counterparts, they have become more numerous and with more varied mandates. The top 10-year performer, with an annualized 22.3% return as of Jan. 31, is the iShares S&P/TSX Capped Information Technology Index ETF. Tellingly, its return since inception in March 2001 is only 7.4%. Much broader index exposure can be had through two U.S. listings: the iShares U.S. Technology ETF and the iShares Global Tech ETF.In an income-oriented spin on tech investing, several Canadian-listed ETFs hold large-cap companies in combination with covered-call options. The Harvest Tech Achievers Growth & Income ETF, for example, writes calls on up to 33% of holdings. This reduces capital gains potential but lowers volatility, while enabling the ETF to make monthly distributions.

    The most aggressive technology ETFs are those that invest in specific themes. Examples include the Emerge ARK AI & Big Data ETF, the Evolve E-Gaming Index ETF and the Horizons Global Semiconductor Index ETF. Though riskier than broadly based tech ETFs, these examples provide exposure to a particular business niche without requiring a bet on a single stock.