Bank of America: Buy these 16 battered tech stocks that will turn strong cash flow into upside, even as the sector loses steam after a decade of dominance

• As the macroeconomy shifts, the end is nigh for technology’s decade-long outperformance.
• But Bank of America analysts say that good opportunities still exist — if investors are selective.
• Investors should consider stocks with strong cash flow, which perform well during rate hikes.

After ten years of consistent gains, the dizzying outperformance of technology stocks may finally be grinding to a halt.

The perfect combination of tailwinds that once propelled tech stocks to dizzying heights are fizzling out, said a team of analysts at Bank of America led by Savita Subramanian, the firm’s head of US equity & quantitative strategy.

The factors that characterized the past few decades of investing in equities include elevated liquidity, disinflation, near-zero interest rates, markets becoming increasingly oligopolistic, and a shift in investment strategy from active asset management to passive, wrote Subramanian in the note from early June. Altogether, these contributed to long-duration growth trends and gave momentum to industry-disrupting, multinational firms — creating the ideal environment for technology firms.

Unfortunately for tech investors, that all seems to be coming to an end.

“Tech was the best sector by a wide margin over the last decade but peak liquidity, trough rates, inflation, passive fund volatility/crowding, anti-monopolistic rumblings and near-shoring pressure represent risks,” wrote Subramanian.

Grinding to a halt

Subramanian pointed to the unwinding of globalization as the first of the technology sectors’ woes.

“Globalization has peaked and companies’ mentions of re-shoring skyrocketed in 1Q. Companies have also become less dependent on China imports since 2018,” she wrote. “Tech can be considered the poster child of globalization, and it sports the highest foreign exposure and the highest emerging markets exposure.”

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Technology firms have also suffered from the COVID-19 pandemic, which created difficult earnings scenarios for many companies because it pulled forward consumer demand, Subramanian explained. And if history is to repeat itself, technology stocks won’t fare well if the economy enters into a stagflationary environment spurred by the mounting oil crisis overseas, she added. During historical periods of stagflation in the 1970s and 1980s, the tech sector was one of the worst performers.

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But this dwindling of technology stocks, which are generally considered growth stocks, may also be part of a greater mean reversion. While growth stocks have taken center stage since the 2008 financial crisis, value stocks have generally outperformed since 1926, Subramanian pointed out. What’s more, as the cost of capital continues to rise, growth stocks will continue to hurt.

Selectivity is the name of the game

Still, this doesn’t spell the end for tech stocks, although it may take some time for the sector to regain its footing. After the dot-com bubble burst in 2001, Subramanian estimated that it took the sector about ten years to recover.

“In the meantime, we would be selective and take advantage of volatility,” she wrote. “We like some tech stocks, particularly those that have drifted into the top quintile of the market by free cash to enterprise value.”

A firm’s free cash to enterprise value, or FCF/EV, indicates its ability to generate cash, and according to Subramanian the metric is one of the best performing indicators out of the seventy her team tracks.

It’s also increasingly important as interest rates rise, because tech stocks with higher FCF/EV ratios are typically strong performers during the first year of a hiking cycle, although they lag behind when interest rates are near zero and cash is “essentially worthless,” Subramanian explained.

To that end, Subramanian and her team identified 16 “beaten-down” stocks within the technology and communication services sector that have both an FCF/EV ratio above 3% and are down over 25% from their market highs, indicating cheap valuation. The stocks are listed below in decreasing order of free cash to enterprise value, along with each company’s ticker and industry.