Mark Lister: Tech companies brace for headwinds

Netflix shares hit a record high last week on the back of a great result, but can it last? Photo / 123RF

With US interest rates set to rise and increasing regulation, the technology sector needs to be prepared.

The high-flying US technology sector has been one of the best sharemarket performers in recent years. It was the top performer in 2017 with a 37 per cent gain, and is number one again so far this year.

It's the most dominant sector in the market, now representing 25 per cent of the S&P 500 index.

However, there are signs of increasing challenges on the horizon. While all those exciting disruptors still have very strong prospects, the outlook has become a little more complicated.

Earnings growth remains well and truly in favour of the tech sector, with profits forecast to grow an impressive 22 per cent this quarter, compared to the same period a year ago. That's well ahead of the S&P 500 average, which is also impressive at 17 per cent.

Netflix shares hit a record high last week on the back of a great result, which exceeded expectations. I'll be surprised if we don't see some equally impressive headlines from the likes of Amazon, Visa, Google and friends.

On the other side of the ledger, rising interest rates and increasing government scrutiny have taken the shine off some of the big tech companies. On the back of an improving economy, better wage growth and expectations of rising inflation, US interest rates are going up. The two-year Treasury yield is at the highest since 2008, and the Fed Funds Rate will soon surpass our Official Cash Rate for the first time in 17 years.

That's a headwind for companies in the tech sector, or at least their share prices.

While sales and customer numbers are growing strongly, many still post only modest profits. Much of their valuation hinges on the profits we expect them to earn in the future, sometimes years from now.

When interest rates are very low, the opportunity cost of waiting for those profits and dividends to arrive is low. Investors aren't missing much, because they aren't getting any return in cash or bonds anyway.

As interest rates rise, that all changes. The opportunity cost of waiting rises, as those other asset classes all of a sudden generate a half-decent income, for very little risk.

In short, because the earnings streams for many tech companies are long dated, investors may not be willing to pay as much for them as interest rates rise.

Then there's the prospect of increasing regulation, which is also a risk to some in the sector. We hadn't heard of most of these companies 10 years ago, but today they are intertwined in our lives and we've become dependent on them.

They've established dominant positions in their industries, and it has become so difficult for competitors. They've become monopolies in some ways.

Having strong market power is a sure-fire way to attract the attention of regulators, while questionable behaviour around privacy issues has also raised the ire of the authorities.

The tech sector is wide and varied, and these risks don't apply across the board to every company. The growth prospects are as exciting as they've ever been, so despite a few headwinds, the tech sector will still tick a lot of boxes for many long-term investors. However, it might not be plain sailing from here on.

• Mark Lister is Head of Private Wealth Research at Craigs Investment Partners. This column is general in nature and should not be regarded as specific investment advice.