A long-overdue reality check for tech stocks has reset the bar for 2023

Published Tue, Dec 20 202211:14 AM ESTUpdated Thu, Dec 29 202210:07 AM EST

For over a decade, technology companies sold the future, promising investors profits down the road in exchange for their confidence — and hard-earned cash. Investors bought that narrative, believing a solid payoff would come. Sky-high multiples and seemingly limitless stock prices only justified those valuations. The environment supported growth at all costs. Money was cheap, and so was access to capital. Interest rates were low, thanks to a relaxed central bank. And hiring boomed as companies hit expansion mode. In 2022, the sector got a long-due reality check. Jumbo-size rate hikes, debilitating inflation and worries of a looming recession pushed some of the world's biggest tech giants toward record lows. Slowing growth and dwindling profits contributed to massive layoffs and cost-cutting — and that's only the start. "Increasing layoffs and fewer job openings signal an acknowledgment of a softer macro, and we believe more cuts are ahead," wrote Jefferies analyst Brent Thill in a note to clients this month. What was poised to be another solid growth year for the sector culminated in one of the biggest routs for the tech-heavy Nasdaq Composite in nearly 15 years, tumbling more than 30%. Software stocks dropped nearly 31%, semiconductors tumbled more than 34%, and technology giants from Alphabet to Meta Platforms sank more than 25%. Against this backdrop, many investors have ditched the sector. Other tech fanatics can't seem to find a place to hide. But opportunities exist in 2023 if investors focus on profitable businesses with strong fundamentals and recession-proof margins, according to some top investors. "We would favor looking at more mature, currently profitable tech businesses, versus trying to catch a falling knife in these unprofitable companies, where the share price is wildly down and even still, they don't look cheap to us," said Bill Callahan, an investment strategist at Schroders. Weeding out the mega-cap duds Mega-cap technology stocks suffered some of the steepest losses this year, plummeting from Everest-high peaks and multiples. Just a year ago, Apple shares traded at a forward price-to-earnings ratio of 32 times on a 12-month trailing basis. As of Monday's close, the stock sat at roughly 22 times. Microsoft 's P/E ratio stood at around 38 times in January; by Monday, it had fallen to about 26 times. Despite the comedown, many stocks still are expensive on a P/E basis when compared with the broader S & P 500, which traded at 18 times earnings Monday. Amazon's P/E, for example, last stood at 78 times. But P/E isn't the only metric investors can use when weeding out the winners from the duds, according to Oakmark Funds portfolio manager Bill Nygren. While most of his holdings are in value sectors such as financials, he's made bets on some mega-cap names. Nygren looks for businesses he expects to return cash to shareholders, but he may, for example, adjust a company's income statement to account for longer-term investments. Alphabet, for example, traded at about 18 times forward earnings as of Monday. But after you adjust for some of the cash on its balance sheet producing minimal earnings, "and you subtract those values from the stock price and add back the losses from other bets," Google's basic search business traded at just 11 times earnings, he explained. Even before Amazon's comedown this year, Nygren viewed shares as fairly valued. Today, if an investor values Amazon Web Services at a similar multiple to other software as a service or cloud companies, even with its higher profit margin, it would mean the investor is getting Amazon's retail business for basically free, he explained. "Now, getting cut in half, you can make the argument that you're paying a fair price for one of the two businesses and you're getting the other one for free," he said. Paul Meeks, a portfolio manager at Independent Solutions Wealth Management, is mostly avoiding Big Tech, with small bets on Apple and Microsoft . He likes Apple's solid management of its inventories, which he said should help it ride out supply issues spurred by China. Continued spending in enterprise IT despite a downturn should bode well for Microsoft, he added. Mike Bailey, director of research at FBB Capital Partners, agreed. While he expects low growth from Microsoft in 2023, its downturn-resilient cloud and enterprise businesses should help it grow — or at least hold on to market share. "They're not screaming buys, but they are among the nicest houses in a bad neighborhood," Meeks said. Loup Ventures' Gene Munster said one of the best risk rewards next year is Meta Platforms. The stock has tumbled 66% in 2022 as it spends on its metaverse vision. Munster expects the stock to benefit as confidence in the metaverse increases, especially if Apple reveals its mixed reality hardware. As of Monday's close, Meta shares traded at 11 times earnings on a 12-month trailing basis, down from 24 times at the start of 2022. The search for recession-proof names Layoffs should persist in 2023 as the technology sector cuts back after over-hiring. So far, about a third of stocks under Jefferies' coverage cut employees this year, with property tech and online auto experiencing some of the worst reductions, according to Thill. CNBC Pro's 2023 sector by sector outlook 2022 didn't go as expected for bank investors. How to avoid pitfalls in the sector in 2023 Health-care stocks are looking good for 2023 and not just because the sector is a 'safe haven' A weak economy will test consumers' wanderlust, but these stocks could prove resilient in 2023 Energy stocks had a blowout performance this year. In 2023, the outlook is more uncertain EV stocks face another turbulent year, but some names are set for big gains, analysts say Continued cuts should bode well for analytics companies such as Alteryx , which offer business insights and tools so that lower-paid workers can do the same job as higher-salaried employees, Munster said. "I think we're going to see a wave of new layoffs early next year, and the way that companies offset those lower head counts is by spending more with Alteryx," he said. Meeks agrees that more layoffs need to hit — and earnings need to come down — for tech's pain to reach its peak. While he's holding more cash to cushion his portfolio, Meeks sees opportunities in some recession-resistant areas. Data networking stocks such as Cisco Systems , Arista Networks and Juniper Networks should benefit as companies build out data centers and shift operations toward the cloud. It's also an area Meeks expects companies to invest in even as they trim budgets elsewhere. P/E ratios for all three stocks have come down significantly this year, with Cisco trading Monday at 17 times earnings, compared with more than 23 times at the start of 2022. When comparing year-to-date stock performance, Juniper shares fared the best, down just 11%. Within the semiconductor sector, Meeks favors names operating within industrials and autos that are better positioned in a slowdown. That includes NXP Semiconductors , Analog Devices and On Semiconductor . Semiconductors suffered this year as consumers cut spending on discretionary goods, although the VanEck Semiconductor ETF tracking the sector bounced back 12% in the fourth quarter. "I don't think tech comes back as much as it did," Meeks said. "A lot of those darlings of yesteryear were consumer electronics-focused, and I think that when we come out of it, we'll have a shift in leadership." Bailey is also betting on some semiconductor stocks with quality businesses and high barriers to entry that should hold up in a recession. Texas Instruments is one name that fits the bill, operating like an industrial company, with long product cycles that cushion it from market share losses, Bailey explained. Shares have sold off more than 11% this year, but held up better than former high flyers such as Nvidia and Advanced Micro Devices , which are down about 45% and 55%, respectively. Texas Instruments' P/E ratio last stood at a little over 17 times on a trailing 12-month basis. To be sure, not every investor views technology positively heading into the new year. Some say retail investors are better off holding more cash until a recession hits, the job market flips and volatility turns over. The Satori Funds' Dan Niles has employed a mix of shorts and longs this year. This strategy has helped his fund rise for the year. Investors, he said, should remain in cash unless they can actively manage their portfolios. Niles expects more volatile bear market rallies in the new year. While risk-averse tech may be the name of the game for 2023, some investors caution opting out of growth altogether. For Bailey, that means slight exposure to more speculative names such as Salesforce and Adobe . "You don't want to put all your chips on kind of slow-growth tech," he said. "Again, you're going to be really missing out if there's some type of recovery."