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ETF Securities Partner Series: How Morningstar values the US tech sector today
ETF Securities Partner Series: How to Identify a Winning Megatrend
ETF Securities Partner Series: Investment Ideas for 2021
ETF Securities Partner Series: How will the U.S. election impact Australian investors

How Morningstar values the US tech sector today

Mar 03, 2021

Finding value in technology Technology investments have seen extraordinary growth over the past decade fuelled by trends such as virtual connectivity and ecommerce. With many technology company valuations at highs, investors may wonder whether this sector still represents opportunity and value in the coming year. Kanish Chugh, Head of Distribution, spoke to Brian Colello, Director of Technology, Equity Research for Morningstar Research Services on the outlook for technology and how Morningstar identifies value in technology companies. Morningstar is the index provider for the ETFS Morningstar Global Technology ETF (ASX Code: TECH). What classifies as a technology company? For many investors, companies like Amazon or Facebook are often front of mind when they consider technology. While these companies have a heavy technology association to their products and services, they are not strictly classified as technology companies. Morningstar defines the technology sector as companies which generate their revenue primarily from hardware, software and IT services. Some examples of this include Microsoft, with a product base spanning computer software, electronics, personal computers and related services such as cloud and databases, or semi-conductor company Intel Corporation, with a product base covering technology accelerators, boards and systems, connectivity devices, processors, memory and storage. Trends in technology The COVID-19 pandemic accelerated activity in the technology sector. While the vaccine news created some recent volatility, the prospects for this sector exist far beyond the pandemic. The outlook for technology is driven by a range of key trends. Mr Colello says, “The biggest one is still cloud computing, so renting out IT capacity in the cloud rather than building it out yourself by buying routers and servers and storage equipment. That’s been the big driver behind Microsoft with Azure.” Other areas offering ongoing growth include big data and analytics, subscription-based software services, artificial intelligence, the internet of things and 5G. In addition to this, “cybersecurity continues to be a focus, especially as people work more remotely and can access networks and software from different devices and in different ways,” he says. Identifying and valuing technology While technology is typically viewed as a growth sector, there’s no question that different parts of the industry may hold different roles in a portfolio. Mr Colello says, “tech might be all things to all investors. In some spots, we think its safety, so names like Microsoft, Adobe, wide-moat software names have been relatively less volatile in COVID than spaces like airlines. In other spots, there’s growth from the COVID trend so names like Zoom, Docusign, following the remote working, work from anywhere trend. In other areas, there’s fundamental growth that’s still growing and will happen whether there’s COVID growth or not. Those are names like Snowflake, Coupa Software, some of the cybersecurity names.” In identifying technology investments, Morningstar are conscious of company valuations and longer-term prospects, with a propriety methodology called the Economic Moat Rating as part of their research process. An Economic Moat refers to the sustainable competitive advantages a company might possess and comes from multiple areas. Mr Colello says, “there’s typically three sources that we identify. The first is switching costs, the stickiness of a business where it is unlikely that customers will switch away from a product or piece of software towards something else. We see this in software all the time. There’s time, effort and financial costs to switch from one software provider to another. There’s always downtime when you switch. There’s a risk of losing or disrupting mission critical data and there’s a learning curve for all the users and anyone who has used the software.” He provides the examples of Salesforce and ServiceNow as companies which have high switching costs and ‘sticky’ customer base. “The second is network effects, where the addition of another member makes the service more valuable for both existing and prospective members,” he says. You may typically see network effects in marketplaces and social media. An example of the network effect in practice is the Google search bar where more queries result in algorithm improvements and in turn, better future results which encourage people to return. “The third is intangible assets. It could be patents or brands, but more often in technology, there’s workarounds so it’s really design expertise and reputation for quality and reliability. We see this a lot in semi-conductor businesses,” says Mr Colello. Price valuations are mixed in technology. Mr Colello views some companies as being overvalued, in some cases by up to 14%. Some examples of companies which he believes may see some pullback are Zoom or Docusign. However, there are also several mature companies which are simply trading at fair value, such as Microsoft. Morningstar’s view on price valuations is informed by its estimate of a company’s future revenue stream compared to its present market pricing. This is used as a screen in many of their indices to include or exclude companies. TECH, for example, selects those companies identified as trading close to fair value or below. Using technology in a portfolio Investors can use technology in a range of ways within their portfolios. Typically, many investors will already have technology to an extent within their investments as a standard sector exposure offering diversification. It is worthwhile considering global technology though as the Australian technology sector is very concentrated and investors may be missing the variation available internationally. Technology can also be used as a thematic investment for exposure to trends driving our world, or to express views (long and short-term) on the direction of the sector.

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How to identify a winning megatrend

Feb 17, 2021

Investing in the major socioeconomic, environmental, and technological themes of our times is becoming more accessible than ever, but how do investors sift through the fads to find the megatrends? Kanish Chugh, Head of Distribution, spoke to James Whelan, Investment Manager for VFS Group (learn more about James here) on his views of the major trends in 2021 and how to identify them for your portfolio. Thematic investing and megatrends Investing in megatrends is a type of thematic investing. It involves considering long-term macro trends, such as robotics and automation, and using various screens and information sources to identify the companies or assets which support this trend through infrastructure or services. Thematic investing is sometimes confused with sector investing. While it’s easy to see how this can happen, thematic investing is more tailored and can span several sectors or even asset classes. To illustrate this, consider the growth trend for technology. While one way to incorporate this might be simply including a sector investment to information technology, a thematic investment might also consider companies outside of this sector classification that also stand to benefit by providing services associated with technology, such as Amazon or Netflix. Thematic investing has increased in popularity over time due to greater access and grew in popularity in 2020 as investors sought investments tapping into the COVID-era, with exchange traded funds (ETFs) a particular beneficiary of this interest. There are some indications this growth will continue and 2021 will be the year of the thematic investment. Mr Whelan says, “there has never been a better time, or a time that has been more accessible for regular retail clients, regular mums and dads at home, or people just on the computer at home, to gain access to those ETFs, and those themes and those areas that they want. Whereas before, you would have had to try and pick out the stocks. There are now ready-made packages for you that you can look at and actually start to pick apart to do the homework for you.” Megatrend or fad? The abundance of often conflicting media describing trends or opportunities can make it difficult to identify whether something is a fad or a long-term growth pattern. Mr Whelan identifies a megatrend using two particular indicators: demographic shifts and government support. “If there is a big demographic shift that's going in, for example, Southeast Asia, the growth in China and Southeast Asia of people moving into the middle class, that's something that's been talked about for ages. What do they eat? What changes do they make? What do they buy? What do they like to do on holiday? All of those things, that's a huge demographic shift… Government stuff. Once the government starts spending money on something, if you're in front of that wave, that's a bottomless pit of money,” he says. Another example of a demographic shift accompanied by government activity is increasing environmental awareness and movement towards clean energy and electric vehicles. Alongside this, government activity on this front has recently ramped up, with local examples being the Victorian Government’s plans to build a new battery storage facility or the NSW Government’s Renewable Energy Pipeline. Investors have a range of options for accessing this, from direct company shares in battery companies to funds such as ETFS Battery Tech & Lithium ETF (ASX Code: ACDC) which collates across the supply chain. By contrast, he views fads as activities with less substance, more noise behind them. “If everybody's talking about it on Twitter and everybody wants a piece of it…Then I think it's a bit of a fad, and I'll have a bit of a look into it. When it’s not a fad is when there’s actually regulation,” Mr Whelan says. He notes that fads can become trends down the track but views government regulation as the key turning point for that. For example, medicinal marijuana stocks spiked a few years ago without accompanying supportive legislation in Canada or any other country and he is wary of investing in this area without the government backing. Trends in 2021 After an unusual and challenging 2020, this year has started with hope as a result of vaccine rollouts and signs of economic recovery. Mr Whelan sees a few trends for the next year. Firstly, small capitalisation companies have shown significant growth in recent times and he views this as backed by economic activity. Mr Whelan says, “after the Biden Government's $1.9 trillion spending budget goes through, we're going to see the US consumer is going to have $2 trillion worth of excess capacity to spend on things, that is absolutely great for small caps and that's going to be very, very bullish for that area.” Economic recovery also brings the prospect of inflation, an area Mr Whelan selects as his second theme. The final theme is more technical and is based on a predicted shortage of a very specific item – semi-conductors. “There is a semiconductor shortage in the world at the moment. Huawei were hoarding semiconductors, before they all got cut off. Electric vehicles now need how many semiconductors? 40% of the cost of a modern car is put on computers. Computers need semiconductors. You've had car manufacturers have to shut down production because they literally cannot get semiconductors just in time because they've been running on just-in-time. When there's a shortage, prices go up. When prices go up, you find a way to meet it,” says Mr Whelan. Rather than investing in individual companies, Mr Whelan has found using ETFs useful for this particular trend as it is difficult to predict which companies will best rise to the circumstances. He cites the ETFS Morningstar Global Technology ETF (ASX Code: TECH) as offering suitable exposure to semiconductors, along with other key technology components. When to move on from the trend Just as it’s important to know whether something is a trend worthy of investment, it can also be important to know when to no longer invest. This comes down to a simple rule for all forms of investment in a portfolio, not just thematic investments. Mr Whelan says, “if the underlying reason as to why you bought it has changed, then you don’t need to be in it anymore. That’s the simple enough reason to be in and out of anything.”

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