OKTA - Tech Stocks Are Soaring In 2023: The 'Why' And What's Next

2023-03-28 06:21:38 ET

Summary

• Tech stocks crashed in 2022 as the once-loved group became the most hated sector in the market.
• Tech stocks are outperforming the broader market by a wide margin this year.
• This is no fluke and this is no bubble: I explain the fundamental reasons driving the surge.
• I discuss my strategies and top picks in the tech sector.

After a tough 2022 which saw many tech stocks drop as much as 90%, many investors may be surprised to know that tech stocks have outperformed the broader market through the first quarter of 2023. After a thorough reset in valuations and expectations over the past year, many tech companies have surprised the market by showing an increased focus on cost discipline, with some companies even greatly accelerating profitability targets. While the tough macro environment is likely to post considerable headwinds to revenue growth in the near term, the market was unprepared for tech companies to show considerable margin expansion in spite of that. In this report, I dive deeper into what's driving the tech rally and where I see alpha coming from next.

Why Are Tech Stocks Rallying In 2023?

In a year in which the S&P 500 ( SPY ) is up only marginally and the S&P Bank index ( KBE ) is down nearly 20%, the Technology Select Sector ETF ( XLK ) is up 16.4% and the Invesco QQQ ETF ( QQQ ) is up 16%.

What is the cause of this outperformance? First, valuations in the tech sector have been brutally reset - check out a snapshot of price to sales multiples across several well known tech names:

With valuations reset, Wall Street may be starting to pay more attention to the underlying fundamentals. It is no secret that the macro environment has become unclear as rising interest rates have increased the odds of a recession. That has had a material impact on the top-line growth rates of many tech companies, which arguably has also helped drive the aforementioned valuation reset. Many enterprise-tech companies have shown resilient revenue growth rates and have outperformed relative to more economic-dependent peers. But tech companies are doing something else rather extraordinary and Wall Street is taking notice.

Take for instance well known tech giant Salesforce ( CRM ), which soared after its latest earnings results. CRM laid off 10% of its workforce, increased its full-year profit margin guidance, and targeted a 30% non-GAAP operating margin in 2 years. CRM CEO Marc Benioff called it "one of the best performances of any enterprise software company our size." To cap it all off, the management team also announced an increase to its share repurchase authorization to $20 billion. The stock recently traded hands at 27x forward earnings.

Okta ( OKTA ) is one of the most beaten-up names in the tech sector, with a stock price down 70% from its peak. The company is guiding for just 17% revenue growth this year - this is a company which was guiding for 30% medium term growth amidst the pandemic.. Yet the stock has performed strongly as of late, largely due to the company showing an increased focus on margins and guiding for $145 million in non-GAAP operating profits this year.

Twilio ( TWLO ) is another heavily beaten-down name. The company is guiding for just 15% revenue growth in the next quarter but is also guiding for up to $350 million in non-GAAP operating profit for the full year and GAAP profitability in 2027. TWLO has authorized a $1 billion share buyback.

This is a very tough macro environment to operate in, but many tech names are showing cost discipline and a desire to return cash to shareholders. These ambitious margin targets would prove highly impressive if achieved amidst the current environment - and that appears to be exactly what Wall Street needed to hear to bring some love back to the sector.

Top Tech Stocks: What To Buy Today

Before we discuss which tech stocks to buy, perhaps we should first discuss which tech stocks should be avoided. "A rising tide lifts all boats" continues to be an important law and many tech stocks which have not shown fundamental strength have nonetheless seen their stock prices rewarded as of late. Carvana ( CVNA ) is one such example with a stock price up 100% from 52-week lows but the company still faces great financial difficulty with no solution in sight.

Yet the other tech stocks to avoid may be less obvious. We can see the top 10 holdings for XLK below:

I am of the opinion that while many of these names are "buyable," they do not come close to reflecting the more attractive opportunities in the tech sector today. Many of these names have not seen significant stock price declines, as high profit margins or attractive secular growth stories have continued to help support their valuations in spite of significant turmoil elsewhere in the sector. With nearly 70% of the ETF centered around these names, investors may be advised to be selective in the sector with active management.

One of my top picks is Alphabet ( GOOGL ), which is one of the tech companies showing increased cost discipline amidst headwinds to revenue growth. GOOGL is using substantially all of free cash flow to buy back stock , a notable observation considering that the stock is trading at 20x earnings. GOOGL fits a theme of targeting stocks with secular growth, profitable earnings, share buybacks, and low valuations. Another idea that takes a more contrarian approach is that in SentinelOne ( S ). Unlike the other tech names which are showing dramatic transitions in profitability, S continues to burn cash even on a non-GAAP basis. But during a period in which investors have little patience for tech stocks without non-GAAP profits, S may be trading with a greater margin of safety. The stock is trading at just 6.5x forward sales with 50% projected growth this year and enough net cash to fund many years of operating losses. I recently named S my top pick of 2023 .

Conclusion

While it may be tempting to disregard the strong price performance of tech stocks as being just the start of another bubble, there are real fundamental factors driving the strength. This is not the same time as 2021, as tech stocks remain well below where they traded just a couple years ago with both valuations and expectations being effectively reset. Investors looking for bargains in the tech sector may wish to focus on names which are undergoing impressive profitability transitions, as well as names which remain unprofitable yet trade too cheap in spite of that. In a macro filled with uncertainty, tech stocks may be offering secular growth at valuations that are adequate for the average investor.

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