Q&A: What to Make of the 2023 Tech Rebound

ETF investors don’t seem convinced. U.S. tech ETFs have lost $953 million in outflows this year, according to figures compiled by Logicly.

VettaFi contributor Dan Mika spoke with Brook Dane, a portfolio manager at Goldman Sachs Asset Management who focuses on technology stocks, on why he thinks the sector is at the start of a strong run.

Dan Mika, VettaFi: If you told someone at the start of this year that tech would be the leading sector in the S&P 500 after a year of recession warnings and a year of Fed hikes, you’d be laughed out of the room. So what happened in the past five months where tech has not just led the S&P, but dominated?

Brook Dane, Goldman Sachs: We were out talking to clients in the beginning of the year saying that we thought there was a great opportunity in tech, and specifically that we thought that valuations had corrected to a level where the risk and reward looked really attractive and compelling to us. I think what you’ve seen this year is a couple of big things that have helped unlock some of the value. And we still think there’s tremendous opportunities in front of us.

What changed from a market perception standpoint was a couple of things. First, we’re at the point now where I feel like you’re getting later in the interest rate cycle. I don’t know when they’re going to stop hiking rates or what’s likely to happen on the other side of that. However, we feel pretty confident in saying we’re through the bulk of the increase in rates. 

That uncertainty around what the interest rate picture looks like? That’s [largely no longer] a risk in the marketplace. People are more comfortable understanding the impact of that on valuations. That led to stocks catching their breath a little bit and finding stabilization. 

In addition to that, the other big driver you see is earnings results in tech have largely been better than expected. I saw a stat the other day that said, coming out of [the first quarter], something like a high-70% of companies beat on revenue and on earnings. The big fear when you went back to last year was not only that rates were going up. But also we had an impending economic slowdown, and across tech, you were going to see big negative revisions in terms of revenues and earnings. And we frankly haven’t seen that. We feel pretty good about the fundamental outlook across the companies we own in our portfolios.

So those two things have really helped the stocks find a floor and start to retrace some of the value that they lost over the past 18 months. Obviously, the other big thing happening out there is the explosion in generative AI and the idea that maybe, we are at the front end of a really important tech cycle. Those three things put together have led to stocks coming up a bit.

VettaFi: How much of these gains are attributable to the mega-caps and Nvidia’s performance versus the smaller-caps in the broader industry? The Invesco S&P SmallCap Information Technology ETF (PSCT B+), the ETF tracking small-cap tech stocks, is also up about 18% this year.

Dane: When we look at the market overall, you’re right that many of the mega-caps have performed very well to start the year. If you look at the FAANG names, they’re up in the mid-30% range. When we look at the opportunity in that more mid-cap space, we really think that’s where there’s a great opportunity for investors to make alpha. The fund we manage, the Goldman Sachs Future Tech Leaders Equity ETF (GTEK C+), is really positioned to take advantage of that.

You have seen the mega caps lead more recently on the AI enthusiasm… There’s definitely some crosscurrents in semiconductors. But semis, especially [data center-focused] semiconductors have done very well. And then pockets of software that will likely benefit from the rise in AI have also done well. In that more mixed mid-cap space, the stocks have done well. But they haven’t done as well as the mega caps have at least to start the year.

VettaFi: You mentioned other pockets of software. Where are you focusing?

Dane: When we’re looking at software companies, there’s a couple things that we’re looking for. First is, what are the valuations? We’re free cash flow-based investors. We’re always looking for risk and reward in terms of where we see upside from an individual stock perspective on the free cash flow. Beyond valuation, we’re looking for where we are different from consensus in terms of the outlook for the next one to five years. What do we think the key drivers of business performance are likely to be? Will it lead to results performing better than what we’ve seen in the broader market?

We think there’s a couple areas that are really exciting. Cybersecurity is an area that we’ve long been invested in. We think that as you move into both this transition to the cloud from enterprise workloads and also the impact from AI, you’re going to see a really nice cycle across cybersecurity. You also will likely see persistent high growth rates faster than what the market is anticipating. Beyond just the U.S. names, we think there are some global names that are really interesting from a cybersecurity perspective, and that investors are largely missing [that].

The second big area from an AI impact perspective is some of the data-related companies. Many of these companies are also consumption-based business models. Think about the Snowflakes, the DataDogs – companies like that, where you had this double-whammy. They saw their stocks (hit) because they have higher expected growth rates that pulled down on the interest rate moves. And then you had this period of cloud optimization where companies were rationalizing their cloud spend. We think we’re coming to the end of that.

You’re going to see a return to more normalized growth out of that area as consumption gets done being optimized. As enterprises take advantage of these AI tools, one of the critical things is, how are they using their data? How are they protecting their data? How are they monitoring their data? That’s going to drive really nice fundamental performance out of those.

And the final piece that we would talk about from a software perspective, is some of the classic SaaS models. Think companies like HubSpot or WorkDay. We think that there’s really good growth as we move across the next two or three years. Companies are continuing to modernize their underlying enterprise resource planning infrastructures.

VettaFi: At the time we’re seeing a lot of tech companies do really well, from an ETF perspective, the flows are risk-off. The Technology Select Sector SPDR Fund (XLK A) has lost $2.6 billion in outflows this year. What do you think is happening there in terms of outlook in the sector?

Dane: I spend all my time looking at the company fundamentals of what we’re invested in and trying to understand what’s changing in those. I frankly worry less about nearer-term market flows. I have spent a tremendous amount of time talking with our clients about their tech exposure. Uniformly, investors who recognize the value of technology drive the conversations. They also recognize how technology is structurally changing the global economy. They want to have exposure.

Last year, there was such a tremendous drawdown in terms of stock prices. And investors are also trying to measure, when do they put risk back on in their portfolios? And when do they think about adding to exposures? The discussion has largely been around, when should they put capital back to work, not if they should. We always tell people to be measured. We say be thoughtful, have a plan, and be methodical about how you put capital back in. 

In terms of day to day flows, lots of things move capital around that are hard to understand one way. I was looking at some of the more specialized tech ETFs lately, and they’ve actually been in positive flows. So I think it kind of depends on which way you look at the market and how you’re slicing it.

VettaFi: How do client conversations differ when they’re looking at a short-term horizon versus a longer term horizon?

Dane: The first thing that I always say when I’m talking with clients is in the very short term, stock prices move for lots of different factors that are very hard to predict. We encourage our clients to think about long-term investment horizons and the risk-reward that they’re putting into their portfolio. We tend not to have a lot of very short-term investors. That’s not the way we structure our funds or manage capital. We’re not a great fit for chase-the-hot-moment investors.

We tend to attract people who have intermediate-term horizons that stretch into the years category. Let’s believe they want to have a certain amount of capital allocated to tech. How do they deploy it in a methodical way? How do they take their time to get to the target exposures? When you have a year like last year where there’s a big drawdown, that actually creates opportunity to build back up the capital in the sector and the exposures that you like.

From our standpoint, it starts with the thesis of why you invested in tech. Our perspective is that tech is the engine of changing and inflecting the global economy higher. It adds productivity, it adds growth to companies, it helps them attract and retain customers. Then you have to distill it down to what kind of tech companies do you invest in?

We’re big believers in finding companies that have durable moats that are generating free cash flow, that can grow sustainably over time. And we think the market has misunderstood one of the growth factors. We’re buying these businesses because we think they can compound out at very high rates for very long periods of time.

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