It is indisputable that our lives are becoming increasingly entwined in – and reliant on – technology, for everything ranging from day-to-day tasks and interactions to medical diagnoses, procedures and treatments.
Simultaneously, businesses are actively integrating technology into their operations, supply chains, marketing and sales, and back offices.
The artificial intelligence industry alone is projected to grow from 2022 to 2030 by a compound annual growth rate (CAGR) of 21.6%. Over the same period, cloud computing is projected to grow at a similar CAGR of 20%.
These are just two of 20 distinct areas highlighting how technology is the epitome of growth and opportunity in the 21st century.
How can technology’s investment potential be captured? While difficult to give a definitive answer, we believe it is not by investing in a passive vehicle that tracks the GICS Information Technology (IT) sector.
The issues with the GICS classification system are three-fold.
First, many of the leading companies of today span multiple industry verticals. Amazon started as an online bookseller before evolving into the e-commerce giant, but it is also the world’s leading cloud computing vendor.
The difficulty in categorizing multi-industry businesses under one sector becomes immediately apparent when you consider that four of the seven companies that make up the ‘Magnificent Seven’ mega-cap technology stocks – Alphabet, Meta (both in Communication Services) Amazon and Tesla (both in Consumer Discretionary) – are not in the IT sector.
Second, technology permeates virtually every industry in today’s economy. Consequently, it can be challenging to determine which criteria should dictate a company’s categorization.
For instance, in May 2023, GICS reclassified eight payment processing companies – including Mastercard, Visa and PayPal – from IT to Financials. It did the same thing in 2018, with Meta, Alphabet and Netflix moved out of IT into the newly created Communication Services sector. With these companies and many others, while the bedrock of their business is technology, their end markets are not.
Lastly, as a result of the 2023 GICS reclassification, just three stocks – Apple, Microsoft and NVIDIA – now comprise more than two-thirds of the IT sector by weight. This lopsided weighting means that an investment in a passive fund tracking the IT sector is essentially a bet on these three stocks.
Technology should be seen as broader than just the IT sector. Technology-driven businesses are not just found in IT, but rather across virtually every sector.
There are a wide range of different industries that are technology driven. In addition to companies like Alphabet, Meta and Tesla, names like Equinix, a data centre company, and CoStar, a technology-enabled real estate service, both in the Real Estate sector, fit within the broader technology universe.
In Healthcare, Intuitive Surgical, maker of the da Vinci robotic surgical system, also falls within the technology rubric. In the Industrials sector, Space Exploration Technologies Corporation (SpaceX) manufactures reusable rockets, operates the satellite-based internet service Starlink, and has the ultimate goal of enabling people to live on other planets. While GICS does not include them within the IT sector, for all these companies and many more, technological innovation is at the core of their business.
A broader, more encompassing definition of technology companies requires an active investment approach because these stocks must be researched simply to be identified. The wide dispersion of returns is another reason the technology space favours active investing.
Results just within the IT sector over the past 10 years illustrate this point. IT stocks that performed in the top 10th percentile returned almost 40% on an annualised basis; stocks in the bottom 10th percentile lost more than 40% annualised.
Put simply, the performance of the companies within this sector varied significantly. This dispersion dynamic existed in nearly every sub-industry within IT, from application and system software companies to internet services to semiconductors and hardware.
The disruptive impact of the rapid pace of innovation and significant breakthroughs in technology is, in large part, responsible for this dispersion. Technology innovation has powered some of the biggest winners in stock market history and driven more upside than any other segment of the market. At the lower end, disruption has caused a significant loss of market share and some outright business failures.
There is little doubt that technology disruption will continue for many years. Generative AI (GenAI) is a case in point. GenAI, which was introduced to the public via ChatGPT in November 2022, is such a transformative technology it was the subject of a key negotiating point in the 148-day strike by the Writers Guild of America in 2023. Many industry experts consider GenAI to be the most revolutionary technology in decades and it is just getting started.
It is increasingly clear that durable secular trends will be the predominant underpinning of market leadership over the long term for both individual businesses and industries. The leading companies driving or riding these trends are finding better, more efficient and cost-effective ways to deliver goods and services. They are leveraging advances in technology – or developing technologies themselves – to disrupt their industries.
These trends include cloud computing software as a service (SaaS) and vertical software and services; artificial intelligence; cybersecurity; e-commerce and electronic payments; digital media, advertising and entertainment; electric vehicles and autonomous driving; and genomics, genetic medicine and modern surgery.
A broader approach to investing in technology can and does capture opportunities that a passive product tracking the IT sector will miss out on. This gap will only grow larger as innovations such as GenAI expand the scope of what technology can do.
For investors, the challenge lies in pinpointing the defining characteristics of the likely winners as a result of technological advancements. In addition to a strong moat and effective capital allocation, businesses must be willing and able to innovate and disrupt themselves to keep up with the rapid pace of technological change. Companies with these attributes are well positioned to maintain their existing success and leverage their competitive edge to expand into new areas, products and services, growing existing markets and even establishing entirely new ones.
Michael Lippert is a portfolio manager and head of technology research at Baron Capital. The views expressed above should not be taken as investment advice.