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Digital Economy: Long-term growth, but limited upside

Digital Economy: Long-term growth, but limited upside

26 Feb 2022

THE pandemic-driven surge in demand for online goods and services has spurred digitalisation as the world went into lockdown. As a result, big-tech companies have enjoyed strong revenue and earnings growth in 2020 and 2021 driving their share prices up.

However, we see signs of an earnings slowdown in 4Q21, with big names like Amazon and Apple facing supply chain disruptions, and Meta Platforms experiencing the impact of Apple’s new privacy policies.

The strong earnings growth delivered by internet companies over the past year may be difficult to sustain in the coming quarters, which could put a lid on further share price appreciation for the time being.

Share price performance of the O’Shares Global Internet Giants ETF

Earnings growth has declined from peak growth in late 2020 and early 2021

Corporate digital transformation the next growth driver

Within the digital economy sphere, we expect segments that are exposed to corporate demand, such as cloud, software-as-a-service (SaaS), and cybersecurity to do well in the coming years. The pandemic was a wake-up call for businesses to speed up the adoption of technology in order to remain competitive as the global economy becomes increasingly digitalised.

Among the big-tech companies, Microsoft and Google have managed to outperform the other big tech players over the past few quarters. A key reason for this is because both these companies are more exposed to corporate demand, offering cloud, digital advertising, and a variety of software products and services. This goes to show that corporate digital transformation will likely be the next growth driver for the digital economy.

Based on our analysis, leading US vendors confirm that corporates have begun implementing a big push towards digital transformation. Additionally, corporate digital transformation will also drive the growth of the cloud computing industry.

From a Goldman Sachs IT spending survey, the majority of the 100 CIOs interviewed expect IT spending to increase from last year, with cloud adoption to double over the next three years.

Although we are not extremely bullish on the near-term prospects of the digital economy, in the long-term, we remain positive on the growth of the digital economy and expect a smooth uptick in demand for digital services as corporates ramp up their digitalisation efforts.

Nasdaq 100 versus the US 10 year treasury rate – 2 year

Companies that have higher exposure to corporate demand are doing well, such as Microsoft and Google

Digital transformation opportunities hold for traditional industries

In the long-term, the growth potential for the digital economy is significant, as many industries have yet to embark on a large scale digital transformation. Over the past decade industries that have gone ahead in digital transformation include the retail, entertainment, and advertising industries which are led by the Internet giants.

However, many industries, including logistics, supply chain, and manufacturing lag behind. But the tides are turning and these industries are expected to catch up over the next few years, making the digital economy an ever more significant aspect of economies.

In the case of the logistics industry, several catalysts including the recent labour shortages in the US, as well as the supply chain disruptions may potentially speed up the pace of digital transformation.

The unemployment rate in the US has plunged to a 22-month low of 3.9 per cent in December 2021, suggesting the labour market is rapidly tightening. As companies scramble for scarce workers, wages are expected to jump to 3.9 per cent in 2022.

Alongside the tight labour market comes the supply chain disruptions, which have resulted in delays across the world. The industry is disrupted across all layers from truck drivers to port managers, to shipping companies, and to businesses.

Bottlenecks persist due to many market inefficiencies. For example, unlike the many seamless apps in e-commerce or e-services, the logistics industry lacks such a smooth seamless booking system, which has exacerbated the disruptions.

Hence, the shortages of manpower and inefficiencies in the logistics industry have pushed companies to accelerate their digital transformation process towards smart factories/manufacturing, which includes automation and transferring workloads to the cloud. According to MarketsandMarkets, the smart factory market is expected to grow at an 11 per cent CAGR from 2021 till 2026 to US$135 billion.

The digital transformation of such industries would in turn drive demand for enterprise softwares such as cloud, software, cyber security and database management, which makes up a total of 44 per cent of the O’Shares Global Internet Giants ETF.

In the near-term, supply chain disruptions should continue to impact Internet companies as goods are delayed. But, in the long-term, we expect these disruptions to spur companies towards digital transformation, reiterating our thesis about the digital economy becoming an ever more significant aspect of economies.

Cloud & SaaS to grow more than double the rate of other digital economy segments

Automation to drive digital transformation

Wages in the US on the rise

Maintain neutral on near-term risks

To sum up, in the long-term we are positive on the digital economy. Digital transformation of corporates and industries is expected to be a growth driver for the digital economy, and we like that the O’Shares Global Internet Giants ETF gives higher exposure to attractive segments such as enterprise software.

It is for this reason we recommend investors to include the digital economy as part of their core allocation.

However, US big-tech stocks have reached record highs as companies continued to beat earnings estimates, pushing valuations to a record high. While share prices of Internet companies have come down recently, as of February 16, 2022, the O’Shares Global Internet Giants ETF is still trading at 44X 2023 earnings, suggesting that it is more or less fairly valued based on the fair PE multiple of 45-times we have assigned for this sector.

The strong earnings growth seen over the past year may be difficult to sustain in the coming quarters. This, coupled with regulatory risks, and a rising interest rate environment may limit the upside of Internet companies in the near-term and hence we maintain a 2.5 Stars neutral rating for the digital economy.

Investors who have yet to include the digital economy in their portfolios but wish to do so at this point may consider using a regular savings plan, before switching to a lump sum investment should valuations come down even further. This will ensure that they buy more units when prices are low and less when prices are high, bringing the weighted average cost down.

For investors looking for actively managed funds to gain exposure to the digital economy, you may consider the TA Global Technology Fund.

Source: The Borneo Post

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