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<p><strong>By: <a href="https://www.franklintempleton.co.za/">Franklin Templeton</a></strong></p>

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<p><strong>Quality, Growth and Valuation—We Focus on that Order, and Always on the Long Term</strong></p>

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<p>We believe that if a technology company has a strong business model with inherent leverage, strong management, and some viable and meaningful competitive advantage, then it can grow sustainably for a long time if it’s in a sufficiently large market. In terms of valuation, our work is always focused on what a business will look like at maturity—<em>not</em> how the market is valuing its near-term earnings, cash flow or revenue performance. We believe investment processes that focus solely on these near-term metrics fail to capture the substantial benefits of sustainable, compounding revenue growth and operating leverage.</p>

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<p><strong>Digital Transformation Should Remain Resilient in 2020</strong></p>

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<p>Investor concerns about slowing economic growth and trade tensions seem to have extended into investor expectations for corporate technology spending. While we believe these concerns are appropriate for legacy technology categories such as personal computers and “on premise” data center infrastructure, our work keeps us optimistic about the multi-year digital transformation (DT) opportunity that lies ahead. Enterprises need to keep investing in their DT initiatives or risk being disrupted. This risk will not abate even if the macro environment weakens, so DT investments should remain robust in 2020. That said, we do expect continued volatility in the semiconductor industry as long as the US-China trade conflict remains unresolved. We also anticipate tariff headwinds for US information technology (IT) hardware companies, some of which build US-bound hardware in China. In addition, we are closely monitoring how the regulatory landscape may be changing for many of the large US internet companies.</p>

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<p>Another concern is increased investor expectations within parts of the software industry. Valuations for many software companies rose significantly in 2019, despite growing signs of economic weakness in Europe and general weakness in legacy enterprise IT spending after a particularly strong 2018. Though we have adjusted our software holdings to reflect our valuation concerns, we are not bearish on the industry’s longer-term prospects. Conversely, we are seeing better prospects within the semiconductor industry and among US and Chinese internet companies, where valuations have become more attractive to us.</p>

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<p><strong>Durable Technology Themes for the 2020 Decade and Beyond</strong></p>

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<p>We remain focused on the highest-quality businesses aligned with the DT theme and its associated sub-themes of artificial intelligence (AI) and machine learning; cloud computing; data science and analytics; the internet of things (IoT); intelligent machines; cybersecurity; software-as-a-service (SaaS); e-commerce; fintech (financial technology); digital advertising; customer insights; next-generation workflow; and software development.</p>

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<p>According to research firm IDC, worldwide DT investments are forecast to approach US$7.1 trillion, based on a compound annual growth rate of 17.5% for the four-year period through 2023.¹</p>

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<p>Essential to DT is the ability to collect and use data to better understand customers, and then to use software and cloud technologies to better serve customers at lower costs. While there is a looming risk that some of the large internet platforms will have their ability to collect and use data curtailed through regulation, we believe these businesses can still operate with only modest amounts of data if need be. Furthermore, these businesses are not only about the data they collect. They work because they aggregate user attention through attractive search, social networking and entertainment services. They then use the collected data to segment and generate insights about the audiences they have built, and make those audiences available to advertisers in an anonymous manner. Their businesses work well because they get the complete value chain right—not just because they collect and combine data.</p>

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<p>Furthermore, we believe small businesses and consumers would be harmed if these models were unwound through regulation. As such, despite the political points that can be earned by focusing on the disruptive power of these companies, we do not believe there’s significant consumer or advertiser interest in breaking these businesses apart. The structure of US antitrust law, which is focused on consumer harm through onerous pricing, doesn’t appear to support a breakup of “big tech” either.  Most of these platforms provide their services free to customers, while advertisers compete in transparent digital auctions to gain access to the platforms.</p>

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<p><strong>We Do Not Currently See Another Tech Bubble</strong></p>

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<p>Despite investor skepticism about some businesses that have masqueraded as technology companies as they’ve recently sought to become publicly traded, we do not believe that we are in a 1999–2000 style bubble. Instead, we believe the IT sector is appropriately valued for the good growth and quality that it offers. In particular, the IT sector has offered the best growth profile in the S&P 500 Index over the past three years, and we think that level of performance should be sustained by the multi-year DT opportunity that is currently underway.</p>

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<p>In terms of quality, IT has been the third most profitable group among the S&P 500’s 11 major sectors.²There are many excellent established, cash- and earnings-generating businesses in this sector, in our view. There are also many emerging IT companies delivering strong growth and good unit economics supported by low churn (meaning the annual percentage rate at which customers stop using a service). We believe this dynamic bodes well for strong, long-term profitability as these emerging businesses mature. In addition, IT capital returns have improved as global technology companies headquartered in the United States can now more easily access their foreign earnings at reasonable tax rates. Many of these companies are bringing this capital back to the United States and applying it to increased share repurchases and dividends.</p>

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<p>Finally, on valuation, the information technology group in late 2019 was trading at a modest but appropriate premium to the S&P 500, in our analysis, given the superior growth and quality that can be found throughout the sector.</p>

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<ol><li>Source: International Data Corporation (IDC), <em>Worldwide Digital Transformation 2020 Predictions</em>, October 2019. There is no assurance that any forecast, estimate or projection will be realized.</li><li>Source: Bloomberg. As of October 2019.</li></ol>

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<p><strong>WHAT ARE THE RISKS?</strong></p>

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<p><strong>All investments involve risks, including possible loss of principal.</strong> Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in fast-growing industries like the technology sector (which has historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing technological advancement. Small and mid-capitalization companies can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies.</p>

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