3 catalysts for technology stocks in 2023

After their worst year in two decades, are technology stocks set for more pain or renewed gains in 2023? Active stock picker Reid Menge identifies three themes that give him optimism.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

For technology stocks, 2022 marked the worst performance year since the bursting of the dot-com bubble in the early 2000s. The technology sector in the S&P 500 declined nearly 30% versus an overall index return of -19%.

As technology sector specialists, fundamental stock pickers and long-term owners of company shares, we are more excited about the opportunities in technology at the start of 2023 than we were entering 2022.

2023: The opposite of 2022

One year ago, technology stock valuations were at all-time highs, interest rates were essentially zero and inflation was a concern but still seen as “transitory.” Against this backdrop, the market was pricing in 75 basis points of interest rate hikes for the year. But a quick reassessment and pivot by the Fed brought rate hikes amounting to 425 basis points in 2022. This dealt a heavy blow to growth-oriented companies with longer-term cash flows, disproportionately affecting the technology sector.

Today, tech is 30% off the highs and valuations in the sector have reset to levels consistent with prior periods of similar rates. Excesses in stock supply have evaporated and hedge fund positioning is at five-year lows. Sentiment, market positioning and valuations are all opposite of one year ago. The lower starting points mean greater room to grow, setting up a more favorable backdrop for 2023.

We see three important themes that could bolster the sector in 2023:

1: Better margins than most

We expect margins for technology companies to surprise to the upside given a sharp focus on expense management after the difficult year. Many young tech companies have not operated in an environment of higher rates and tighter money supply and, therefore, had lacked financial discipline. That has changed and we now see companies prioritizing margins over growth ― many for the first time. In a market concerned about corporate earnings, we believe technology will be relatively more attractive.

2: Big year for mergers and acquisitions (M&A)

We expect to see increased M&A activity in the technology sector. Software clearly will consolidate this year, in our view, with much moving into private equity where there is $1 trillion in cash waiting to be deployed. Software companies broadly derated to 5x revenue last year. We are already seeing private equity deals priced at 8x multiples. Such healthy premiums are likely to fuel a takeout wave. After a very bad year for software ― down 40% overall in 2022, with the high-growth segment down 60% ― we expect either public investors will recognize the value or private equity will.

3: Generative Artificial Intelligence (AI)

For those who were waiting for the next big innovation in technology, it has arrived. Despite the dismal year for technology stock performance in 2022, the industry saw meaningful innovation breakthroughs. One of the most significant was generative AI, which is essentially artificial intelligence that creates. It can write text, draw pictures, compose music and generate code ― all at a superhuman level.

The use-cases across businesses are endless, in our estimation, with potential to be extraordinarily disinflationary and change the long-run outlook for human labor. Initial investment opportunities are in the semiconductors that can support the computational needs of this ground-breaking technology. We see generative AI as the most revolutionary tech since the internet, with investment opportunities available now.

Where are the worries?

Of course, the Fed is still active in hiking rates to combat inflation and investors remain wary. We expect continued market volatility. We are also watching data center capital expenditures (cap ex) among the big buyers of tech. Movements up or down in the cap ex spending of these key players will drive the fortunes for the technology industry ― across networking, databases, operating systems, applications and servers. The outlook is for data center cap ex to slow in 2023 in response to a broader economic slowdown. That said, we also are in the midst of an AI arms race and these big players will not want to lose an edge by cutting their spending on key innovations.

We are optimistic in the long-term outlook for technology stocks. As the sector looks to rise from the rubble of 2022, we believe an active approach to stock selection that focuses on individual company fundamentals can make an important difference in portfolio outcomes.

Risk warnings

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