Within IT, a few companies steal the show
Information technology (IT) stocks are doing very well again this year, with the IT sector outperforming the broader equity market. But if you look a little closer, you will see that not the entire sector is participating. The strong performance is predominantly driven by a specific part of the sector: mostly by companies with a strong link to artificial intelligence (AI). And within this market segment, it’s mainly chipmaker Nvidia that steals the show. Meanwhile, sector valuations have increased. And due to the fact that the rally in IT is not very broad-based, risks are starting to emerge.
Much has been said in recent years about the group of stocks dubbed the ‘Magnificent 7’ – Apple, Amazon, Alphabet, Microsoft, Meta, Nvidia and Tesla. These stocks, except for Tesla, are currently at or near their all-time highs. But Nvidia is the real winner: the maker of semiconductor chips gained more than 150% since the start of the year. Indeed, the rally that is taking the whole technology sector to higher levels is mainly based on the strong stock performance of semiconductor companies. The other two IT subsectors – software & services and IT hardware – have not joined this rally and are even lagging the broader market a bit.
AI is the magic word
The magic word is still AI. But the rise of AI is not beneficiary to the whole IT sector yet. In equity markets, investors’ enthusiasm is mainly focussed on specific companies that facilitate the use of AI. Semiconductor companies in particular are benefitting from the rise of AI, as semiconductor chips are indispensable for AI applications. This has sparked a rally in stocks of semiconductor makers and companies that provide equipment to produce these chips.
By contrast, most software companies have not fully benefited from the AI trend recently. This is partly because the challenging economic environment is starting to have a detrimental impact on the growth prospects of software companies. In addition, clients of these companies appear to be in ‘wait-and-see’ mode, as they are assessing what AI eventually will mean for them before they start placing more orders for AI-related software. This has made investors a bit more hesitant towards this subsector. Eventually, software companies that provide AI-related products and services should start to benefit from the AI trend as well. But this will take more time than initially expected. Growth within the software & services sector is currently slowing, which makes the relatively high valuations of stocks in this subsector less justified.
The IT hardware subsector consists largely of Apple, but also includes companies such as Cisco and Arista Networks. This subsector should slowly but surely start to benefit more from the AI trend, as the need for fast networks continues to increase. Networking vendors should start taking advantage of this and some companies already do. So far, however, only a couple of stocks within this subsector have been able to join the rally in IT stocks.
Risks on the horizon
As the recent outperformance of the IT sector is largely due to the strong gains of semiconductor stocks, the rally is not broad-based. Meanwhile, risks related to the sector are also starting to increase gradually. Within the semiconductor subsector, we see the risk of lower chip demand. Once customers have sufficient semiconductor chips to achieve their AI goals, semiconductor companies could see a sharp drop in orders. In addition, equity valuations in this subsector have become relatively high, due to the rally in these stocks. Moreover, in the subsector software & services, prospects have become a bit more uncertain.
For these reasons, we now prefer a neutral allocation to the IT sector within our investment strategy.
Joost Olde Riekerink
Equity Research & Advisory Expert