High-quality tech stocks remain resilient

High-quality tech stocks will continue to outshine the broader market, regardless of interest rate movements, says a portfolio manager at CIBC Asset Management.

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Following last year’s shift in interest rates, CIBC’s Robertson Velez said many anticipated a negative impact on stocks, especially those dependent on future cash flows. Tech stocks in particular, often seen as “long-duration” assets due to their growth potential, were expected to bear the brunt of this change.

Velez, however, challenges this view, saying the real impact of rising interest rates depends on a company’s financial health.

According to Velez, companies relying heavily on debt or struggling with profitability are most at risk when rates rise, leading to lower profits or even bankruptcy.

“This is the real risk if rates stay higher for longer for most companies,” he said.

However, tech giants are not most companies, Velez said.

Many large-cap tech companies have little debt, generate ample free cash flow and maintain revenue growth even in tough times. These companies have also adapted to the changing economic landscape by cutting costs and becoming more competitive. As a result, Velez said, they are less vulnerable to rising interest rates.

The market recognized this earlier this year, Velez said, and a small number of high-quality, large-cap tech stocks have since led the overall recovery in 2023.

Beyond their resilience, Velez said specific reasons behind the performance of some tech stocks can be attributed to the introduction of generative AI by Microsoft and the strong demand for infrastructure equipment reported by Nvidia.

However, while he agrees with generative AI’s potential, he said the undervaluation of these tech stocks at the beginning of the year would have inevitably triggered growth, whether through generative AI or another technological advance.

Looking ahead, he said these stocks will continue to be attractive.

“Regardless of what happens in interest rates, I expect that they will outperform the broader market,” Velez said.

In this environment, he recommends tech companies “that have high revenue growth, high free cash-flow margin, and high return on invested capital.”

In addition to Microsoft and Nvidia, he named Apple for its track record of successful platform expansion, and Broadcom, which has grown by adapting to structural changes.

Conversely, Velez advised caution when considering unprofitable tech companies or those with significant debt that their cash flow can’t comfortably handle. Examples of this are small and mid-cap companies with high growth rates that experienced a surge in prices during the pandemic but have since struggled to regain their footing.

However, if central banks lower interest rates, Velez said tech performance should expand to include smaller, high-growth companies. He said these firms will become more attractive as concerns about running out of cash diminish.

Additionally, companies with high debt-service costs will benefit from lower interest rates, which will improve their profit margins.

While Velez remains committed to quality, he said that a more favourable interest rate environment could broaden opportunities for quality tech companies. This could lead to more investments in mid-cap, small-cap and international tech firms.

To address concerns about overvalued tech stocks, Velez recommended investors take a wider view, noting that many tech stocks have not yet returned to their pre-2022 levels. In addition, he said long-term factors like generative AI and other technological advancements could offer significant growth opportunities.

“There are a lot of long-term drivers of technology, and I think that there’s still a long runway for growth going forward regardless of the interest rate environment,” he said.

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.