Digital Transformation of Industry and Finance Is Just Starting
cyclical businesses

Digital Transformation of Industry and Finance Is Just Starting

Technology stocks have come roaring back. Now, investors are questioning if fears of higher interest rates and stretched valuations have been overdone.

The Nasdaq Composite index soared 464 points Tuesday to 13,073, a gain of 3.7%. It was the best single-day advance in four months and broke a losing streak that saw the tech-heavy index fall 10% from its March highs.

The market is speaking.

Let’s be clear, the idea that technology stocks are being sold because interest rates are rising is fiction. It’s simply not happening.

It’s true that professional investors worry about valuation when interest rates rise … but context is important. The yield for the 10-year treasury note is now 1.5%. While that is well above where it had been over most of last year — less than 1% — it’s still historically low.

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More importantly, bonds as an investment class represent no competition to stocks. Forget that the yield is only 1.5%. Bond buyers must also contend with real inflation rates near 2% and a coupon paid in U.S. dollars that are declining in value almost daily. The idea that institutional investors are shifting money out of companies like Microsoft Corp. (Nasdaq: MSFT) into bonds is beyond ridiculous.

What’s happening is pros are looking for sectors that are likely to show the best year-over-year earnings growth in 2021.

Gabriela Santos, global market strategist at J.P. Morgan Asset Management, told CNBC that financial companies in aggregate could see a 40% increase in earnings during 2021. Consumer discretionary businesses might grow their bottom lines by 70% as the pandemic fades and stores reopen. Meanwhile, technology companies are expected to grow profits by only 10% because their earnings were largely not suppressed by the pandemic and therefore don’t have to make up ground.

In this context the choice is clear.

Money is being funneled to cyclical sectors where it’s expected to yield the greatest rate of return. This is not new or based on tricky economics … but there are some caveats.

My research suggests technology businesses that have become digital transformation facilitators will continue to post earnings growth far in excess of 10%. Also, not all cyclical businesses will perform well even as the economy reopens. In other words, this isn’t one of those markets where investors can choose any cyclical business and mint profits.

This is because transformative digital innovation is disrupting many parts of the cyclical economy.

It’s currently much more difficult for banks to charge money transfer fees when financial technology companies like Square, Inc. (NYSE: SQ) and PayPal Holdings, Inc. (Nasdaq: PYPL) have made shifting currency inside smartphone apps ubiquitous and free.

Investors are better off seeking out financial sector companies with durable competitive advantages like Mastercard Inc. (NYSE: MA) and Visa Inc. (NYSE: V), or businesses that are undergoing internal digital transformations. Managers at The Goldman Sachs Group, Inc. (NYSE: GS) and JPMorgan Chase & Co. (NYSE: JPM) are miles ahead of the competition in the race to digitize the sector.

The same sort of thing is happening throughout C suites at Ford Motor Co. (NYSE: F), General Motors Co. (NYSE: GM), Caterpillar Inc. (NYSE: CAT) and Deere & Co. (NYSE: DE), just to name a few. It might seem hard to believe that very soon Detroit will be home to the fastest growing electric vehicle companies in the world. Autonomous vehicles, another hot investment story, have been a thing in Illinois forever if you count giant earth movers and tractors.   

While Whirlpool Corp. (NYSE: WHR) may be best known for its household appliances, in 2015, managers began investing heavily in software infrastructure to digitally tie factory floors to accounting and supply chains. The result has been a huge boost in profitability and a competitive advantage that is certain to reveal itself as economic activity picks up this year.

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Professional money managers are moving money into all of these businesses as they seek greater exposure to an economy that looks more like 2017 than 2020.

This does not mean rank and file investors should abandon technology. The process is not zero sum.

A stronger economy means even more spending for transformative digital tools. Facilitators should continue to grow quickly. The current share price weakness means there are bargains galore. This is the time to for selective buying, not fretting.

Big market declines and subsequent rallies speak volumes about what is really happening. The digital transformation theme that led to tech outperformance in 2020 is simply shifting to other sectors.

It’s another big opportunity. Don’t miss it.

Best wishes,

Jon D. Markman

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