Powering Up: Technology Continues to Drive the Markets
American technology companies have powered the market gains of the past five years and the astonishing 48% surge in the S&P 500 from pre-pandemic highs.
The sector’s four biggest constituents (Apple, Microsoft, Amazon, and Alphabet, the parent of Google) now generate average annualized profit margins of 25% and account for 21% of the S&P 500‘s market capitalization. Their ability to consistently maintain these extraordinarily high margins ranks them among the most successful companies in the 200-year history of limited liability corporations. No other country has anything to rival them.
Now what? The recent market correction could be attributed to a growing recognition among investors that valuations, while not at record levels overall, need to come down in the face of higher inflation and prospectively higher interest rates. Or it could signal that future earnings may come in significantly below the consensus projection of 9% growth rate for this year and 10% for next year.
Either way, revenues are not likely to disappoint, assuming the pandemic ebbs and fairly high nominal economic growth continues. But can the technology giants, and by extension, the S&P 500, continue to generate record-high profit margins in the face of increasing costs? There are good reasons to think so, at least until we see evidence to the contrary.
First, the economy-wide investment in software, computer equipment, and research and development is growing at a rapid pace relative to GDP. As described in Investing in a Digital Future By Michael Kirkbride, we believe this growth rate will continue or increase. Companies are searching for ways to replace labor with technology.
Of course, some companies and entire sectors will be able to make this shift more easily than others. We are constantly on the lookout for the technology companies providing the best solutions, and for the companies in other sectors most likely to benefit from implementing that technology. One of the best examples of broad-based productivity enhancement through technology is the transition of most business software applications to the cloud. The major cloud providers, such as Amazon and Microsoft, are able to significantly reduce the cost of running essential business software for non-tech companies, as well as allow new companies with disruptive ideas, like Uber and Netflix, to scale quickly and easily. As remarkable as it seems, given all the technological changes of the past decade, we are still in the early stages of businesses moving to the cloud.
Second, many of the companies implementing technology into their businesses will themselves be able to increase productivity at a fast enough pace to offset current wage price increases. Those facing rapidly increasing labor costs are particularly incentivized to replace labor with software-driven technology if possible, a self-reinforcing virtual circle, at least from a profitability viewpoint.
Third, technology companies are also increasing their own rates of productivity, providing increasingly more powerful products and services at lower prices per unit of utility. Software companies are unlikely to suffer from the current spike in wage inflation. While great software engineers don’t come cheap and there is a shortage of programmers in this country, that could soon change if related visa restrictions are eased; otherwise these jobs will move offshore.
Indeed, it could be argued that the profit margins of software companies are understated, because their biggest current expense – paying coders to write new software – represents their biggest investment in the future. Established software companies have very little need to reinvest profits in traditional capital investments to drive future growth, so they are free to use their profits for dividends or share buybacks.
Most other sectors have healthy margins, notably pharmaceuticals, but not at anything like the tech industry levels – and they require the reinvestment of over half their profits to grow. The productivity of software companies as measured by revenue and earnings per employee remains unrivaled, and that productivity grows as software gets written on top of established programs. In addition, the application of the software a company sells enhances the productivity of the purchaser.
Fourth, we think the large tech companies will manage to maintain their high profit margins and that the implementation of software by companies in other sectors will reduce the risk of a wage-price spiral. One caveat: The large software companies currently pay very little to no corporate taxes because they are able to move their most valuable assets – the licenses on the programs – to tax havens. Although it’s easier said than done, the United States and other major countries would like to see the giant tech companies pay more tax. There is also rising political pressure to rein in these companies through increased regulations and antitrust legislation, which we will be monitoring.
So, there are some good reasons to remain positive about the technology sector in particular and the United States in general. However, we are mindful that our clients have enjoyed high returns over the past decade from their large-cap technology investments. We continue to hold significant positions in these companies but remain careful to rebalance portfolios as appropriate, taking profits and reinvesting in companies likely to benefit as the economy fully reopens – and technological advancement and adaptation powers on.
John Apruzzese is the Chief Investment Officer at Evercore Wealth Management. He can be contacted at apruzzese@evercore.com.
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