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Tech Stocks Poised to Benefit from Rising Rates

Posted by Tamer N. Elshourbagy on Feb 15, 2022 1:52:03 PM

If you follow any business news channels or investment publications, you might be surprised by this blog. Conventional wisdom suggests companies trading at a less expensive valuation and directly tied to the cyclicality of the economy are better bets on the market as rates move higher.

As investors grapple with inflationary pressures, an accelerated timeline of Fed tightening, rising interest rates, and the impact of the latest COVID variant, investor sentiment has once again shunned technology stocks with a rotation to economically sensitive sectors of the market.

In my twenty plus year career, a year doesn’t pass without investors debating the merits of owning cyclically tied value stocks over growth stocks. This debate seems as popular as the debate over whether Tom Brady or the legendary Joe Montana takes the title of greatest quarterback of all-time. While the merits and accolades of both athletes will be debated for decades to come (I’ll take Montana any day), naysayers suggesting the sun has set on tech stocks might be surprised to learn otherwise.

In theory, tech stocks are believed to be facing a number of headwinds given their relatively expensive valuations and decade long outperformance versus the broader market. Market pundits point to a ‘reversion to the mean’ on tech valuations contracting as another reason why stock prices are expected to experience further weakness.

Generally speaking, robust cash flows for tech companies are less attractive in a rising rate environment, causing analyst teams on Wall Street to frantically adjust their discounted cash flow models. Less cash flow imputes a lower valuation for what investors are willing to pay for a business. This makes sense on the surface, but the valuation of a business is more than what’s on an excel spreadsheet. Factors such as consistency of cash flows, competitive dynamics, moats around businesses, the quality of management teams, and future growth opportunities, etc. are characteristics not always apparent on an elaborate valuation model.

For arguments sake, our focus as long-term investors is on high quality companies, not on businesses without earnings, free cash flow, or trading on an irrational multiple to sales. Let’s discuss why tech stocks in a portfolio are positioned to benefit in the current environment and beyond.

Inflation benefits technology companies…A LOT – As businesses pass through higher prices to offset cost inflation, tech companies are poised to benefit considerably. Many leading tech companies have a recurring stream of revenues from subscription-based services allowing for price increases to flow straight to the bottom line. Consider a company such as Apple – the company enjoys strong margins across all products and collects a steady stream of revenues from subscription services such as cloud storage, music, apps, etc. Marginal increases in pricing flows straight to earnings.

Microsoft recently announced its first price increase for Office 365 since June 2011. The $1 to $4 monthly increase (depending on the service) is likely to be met with little resistance as businesses and consumers have very few alternatives to Microsoft’s office suite of products.

In their recent quarterly earnings, Amazon announced a price increase for annual prime membership from $119 to $139. Those of us accustomed to coming home to a daily stack of brown boxes sealed with Amazon prime tape can vouch for the stickiness of the Amazon model. Arguably, the convenience and pricing of the service could justify paying on upwards of $200 annually. These increases largely flow straight to the bottom line for the business.

Tech companies are among the businesses with the highest operating margins, return on capital, and generate the highest free cash flow per share. Historically, many have seen revenues accelerate faster than expenses resulting in a significant amount of leverage over expenses.


Tech stocks do just fine as interest rates rise – Over the last 15 years, periods of rising rates have been accompanied with rising stock prices. If you consider the 10-year Treasury bond, periods when the yield moved higher from trough to peak resulted in stocks up double digits. Notably, tech stocks outperformed the S&P 500 in 4 out of the 5 time periods listed below.


The recent economic downturn demonstrated the resiliency of technology – Our focus as long-term investors is downside protection – particularly in the businesses we own and the fund managers we invest with. Investors were reminded of the importance of healthy balance sheets and free cash flow as the economy came to a screeching halt during the height of the pandemic in 2020. Tech companies have historically generated high levels of free cash flow and generally hold cash rich balance sheets, providing for a margin of safety during times of uncertainty. Many are secular growers with capital expenditures funded by internally generated cash flow and rely less on the capital markets to fund growth. This helps insulate tech companies from the higher cost of debt as interest rates rise.

During the recent downturn, we witnessed an acceleration in digital transformation as consumers and businesses were forced to embrace technology at a meaningful clip. Nowadays, our reliance on technology is becoming less discretionary and more a necessity. Businesses are relying more on platforms such as Google for a digital presence and marketing to remain relevant to customers. Both consumers and businesses rely heavily on digital banking and payments processing for convenience, security, and flexibility and this will continue into the future. Doctors and research scientists are using technology everyday in finding new therapeutics, surgical procedures, and personalized treatment. Traditional industrial companies such as Waste Management (WM) are using cutting edge technology to turn waste from landfills into renewable natural gas (RNG). The technology is used to power its truck fleet and natural gas distribution. Technology is also being deployed in their recycling business to help automate the recycling process, reduce costs, and improve product quality. Utilization of technology is growing rapidly across every sector of the market and provides a buffer to tech companies with less sensitivity to economic downturns.

While we manage well-diversified strategies with exposure in nearly every sector and style of the market across the global landscape, we believe long-term opportunities in technology remain robust. We believe we’re in the early innings of a technological revolution with consumers and businesses rapidly embracing technology for decades to come.

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The opinions expressed and material provided are for general information only.

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