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Four leading tech stocks now look cheap

The recent drop in technology stocks has created some rare buying opportunities for investors looking to add or expand exposure to the technology sector. However, given the level of economic uncertainty and jitters over higher inflation and rising interest rates, investors should be careful in their stock selection. Luckily, the relative underperformance so far this year of the tech sector compared to the benchmark may make things easier.

The Morningstar U.S. Technology index (just under 6%, expressed in U.S. dollars) is currently underperforming the S&P 500 (over 11%) for the year to date, as of May 27, 2021. However, the tech sector has handily topped the broader index over the one-, three- and five-year periods.

These tech heavyweights in Morningstar’s coverage universe are trading at double-digit discounts to their fair values, indicating potential for upside. The sizeable margin of safety and strong fundamentals make these names compelling prospects for economic reopening and advertising growth play.

Microsoft Corp (MSFT)

  • Price: US$250.16
  • Forward P/E: 30.21
  • Fair Value: US$278
  • Moat: Wide
  • Star rating: ****

Data as of May 27, 2021

Tech major Microsoft (MSFT) is the second most valuable company by market cap, behind Apple. Best known for its Windows operating system and Office productivity suite, the company develops and licenses consumer and enterprise software. The firm’s business comprises three segments: productivity and business processes, intelligence cloud, and personal computing.

Under CEO Satya Nadella, Microsoft has reinvented itself into a cloud leader. Additionally, the company has accelerated the transition from a traditional perpetual license model to a subscription model, while divesting from low-growth low-margin business. “These factors have combined to drive a more focused company that offers impressive revenue growth with high and expanding margins,” says a Morningstar equity report.

The tech heavyweight’s cloud service platform Azure has grown to become the crown jewel of the company. “Azure is an excellent launching point for secular trends in AI, business intelligence and Internet of Things, as it continues to launch new services centred around these broad themes,” asserts Morningstar equity analyst, Preston Caldwell, who puts the stock’s fair value at US$278.

Microsoft is also moving some of its traditional on-premises products to cloud, including such critical applications as LinkedIn, Office 365, and Dynamics 365.

Alphabet Inc (GOOG)

  • Price: US$2,428
  • Forward P/E: 31.75
  • Fair Value: US$2,925
  • Moat: Wide
  • Star rating: ****

Data as of May 27, 2021

Silicon Valley giant Alphabet (GOOG) is best known for its search engine Google, which generates 99% of its revenue. The company’s other revenue streams include sales of apps (Google Play), video streaming business (YouTube) and hardware (Chromebooks and the Pixel smartphone).

Wide-moat Alphabet recently saw a 2% decline triggered by fears of rising rates and a slowdown in digital ad spending growth. These fears are disputable and while rising rates should pressure multiples, Alphabet has “already been trading at what we view as unwarranted discount compared with peers,” says a Morningstar equity report.

As for the ad revenue declaration in the second half of 2021, the report assures it would be a short-term effect resulting from the pandemic. “We expect digital ad revenue growth will remain at strong double-digit rates for both firms [Alphabet and Facebook] for several years,” says Morningstar equity analyst, Ali Mogharabi, who pegs the stock’s fair value at US$2,925.

Alphabet boasts sustainable competitive advantages built on the company’s significant intangible assets including technological expertise in search algorithms and machine learning, as well as access to and accumulation of data that is deemed valuable to advertisers.

Facebook Inc (FB)

  • Price: US$331.03
  • Forward P/E: 27.40
  • Fair Value: US$390
  • Moat: Wide
  • Star rating: ****

Data as of May 27, 2021

World’s largest social network with 2.5 billion monthly active users, Facebook (FB) provides a platform for users to exchange messages and share news events, photos, and videos. Advertising revenue represents more than 90% of the firm’s total revenue, with 50% coming from the U.S. and Canada and 25% from Europe.

Facebook’s sticky ecosystem comprises the Facebook app, Instagram, Messenger, WhatsApp, and many features surrounding these products, which helps the company amass valuable user data. “The growth in users and user engagement, along with the valuable data that they generate, makes Facebook attractive to advertisers in the short and long term,” says a Morningstar equity report.

While Facebook has been facing fierce political pressure over its handling of data, “advertisers will continue to allocate a higher percentage of their ad budgets” toward Facebook due to the platform’s colossal user base, says Mogharabi, who estimates the stock’s fair value to be US$390. He remains confident that the wide-moat firm will benefit significantly from the economic recovery as ad spending perks up.

Tencent Holdings (TCEHY)

  • Price: US$78.35
  • Forward P/E: 33.90
  • Fair Value: US$103
  • Moat: Wide
  • Star rating: ****

Data as of May 27, 2021

Chinese internet heavyweight Tencent (TCEHY) offers a wide variety of internet services and contents. The firm’s main services include communication and social networking, online PC and mobile games, content (news, videos, music), cloud services, and financial technology.

Tencent’s social media app WeChat (locally known as Weixin) has 1.2 billion aggregate monthly active user base while its instant-messaging software QQ has 600 million users.

The wide-moat company has been investing in areas with strong competitive advantages including cloud, business services, enterprise software, and high production value games targeting the global market. “The trend for enterprises to digitalize, especially in light of COVID-19, and the proven business model of cloud in the West has established the need to invest in business services,” says a Morningstar equity report.

As well, the Chinese tech juggernaut’s short-form video strategy has improved to include both the long- and short-form video platforms.

Tencent is particularly ambitions to expand its dominance in the global gaming industry. “It leverages globally popular console and PC gaming IPs of its investees or popular anime IPs and develops mobile games for the international market,” notes Morningstar equity analyst, Chelsey Tam, who appraises the stock to be worth US$103.

 

Vikram Barhat is a Toronto-based financial writer. This article does not consider the circumstances of any investor and you should consider financial advice to check whether these stocks are suitable for your portfolio.


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