The tech sector is extremely broad. It is filled with trillion-dollar behemoths like Microsoft (MSFT 1.82%), legacy providers like IBM (IBM -1.05%), and fast-growing upstarts like Crowdstrike (CRWD 2.03%). It spans hardware, software, cybersecurity, financial technology, and more.
As such, 2021 could have either been a rough ride or a massive success for tech stock investors, depending on which market corner they were focused on. But overall, the tech sector did well -- much like it had over the past decade. Will 2022 be the year where it runs out of steam?
Image source: Getty Images.
Top-heavy dominance
The S&P 500 (SPY 0.95%) is market-cap weighted, so the largest companies by valuation have much greater impacts on the index's movement. Out of the top 10 companies in it, seven are tech players, and they make up around 25% of the entire index's value. As a group, those seven companies had a fairly remarkable 2021, though two did underperform the market.
Total Return Level data by YCharts
When 25% of the S&P 500 has a great year, it makes sense the entire index will follow. Should these companies falter, they will drag the market down with them. However, these seven companies have had the business growth to back up their share price gains.
Revenue (Quarterly YoY Growth) data by YCharts
Each has been capturing the opportunity in front of it, and there is little reason to expect that will change significantly this year. If these seven continue succeeding, the tech sector as a whole will continue its success during 2022.
The high flyers
In contrast to the largest and most well-known tech companies, a cohort of high-growth, unprofitable tech businesses delivered terrible results for investors in 2021. Cathie Wood's ARKK Innovation ETF (ARKK 1.05%) invests in many of these stocks, and it fell by 23% over the last year. Valuations for companies such as Roku (ROKU -10.29%), Twilio (TWLO 1.47%), and MercadoLibre (MELI 3.09%) have cratered, and many of their tech brethren have fared poorly also.
In many cases, their valuations have returned to pre-pandemic levels. This is because revenues are catching up to the price movement, normalizing the stocks' price-to-sales ratios.
| Company | Share Price as of the End of Q3 2020 | Q3 2020 TTM Sales | Q3 2020 P/S Ratio | Current Share Price | Q3 2021 TTM Sales | Current P/S Ratio |
|---|---|---|---|---|---|---|
| Roku | $188.80 | $1.540 billion | 15.17 | $227.93 | $2.549 billion | 9.67 |
| Twilio | $247.09 | $1.545 billion | 22.39 | $262.34 | $2.547 billion | 15.05 |
| MercadoLibre | $1,082.48 | $3.320 billion | 16.14 | $1,129.69 | $6.265 billion | 8.62 |
Source: Macrotrends. Stock prices listed are as of Sept. 30, 2020, and Jan. 7, 2022. P/S = Price to sales. TTM = Trailing 12 months.
Now that their valuations have fallen, the stocks' movements should be more correlated to quarterly results. Because of this, I believe these high-growth stocks should see a solid year in 2022, as these companies' market opportunities haven't been fulfilled. However, with the Fed poised to begin increasing the benchmark fed funds interest rate from its current extremely low level, investor appetite for unprofitable companies is likely to begin deteriorating. Macroeconomic events may have a larger impact on these companies' stocks than their own results, further complicating their investment theses.
Are pandemic changes here to stay?
Many thought the worst of the COVID-19 pandemic was over as 2020 drew to a close; 2021 proved that wrong. While nobody knows for sure what 2022 has in store, two years of remote work have changed how businesses operate. Spotify (SPOT 0.20%) and Twitter (TWTR) have decided to let employees work from home forever if they want to, while many others companies' management teams are taking a hybrid approach.
As such, digital collaboration tools have never been more important. Although the initial stock hype has worn off for Zoom Video (ZM 1.57%) and DocuSign (DOCU -0.26%), they have become ingrained in the workflows of vast numbers of organizations. As a result, businesses will likely continue their usage. Additionally, each has a knack for expanding customer spending.
| Company | Q3 Net Retention Rate |
|---|---|
| Zoom Video | 130%-plus |
| DocuSign | 121% |
Source: Zoom Video and DocuSign
For every dollar the average customer spent in Q3 2020 with Zoom Video and DocuSign, they now spend at least 30 cents and 21 cents more, respectively. Companies that can drive growth because of how integral their products are to their clients' operations will not see a market top. Those that offer solutions that are not as necessary will struggle if businesses start calling everyone back into their offices.
Will the tech sector reach a top in 2022?
As the tailwinds toward a more digital society intensify, the companies providing these solutions will succeed. While there may be some struggles within the tech sector, overall, I expect it to continue growing into 2022 and beyond. Many individual stocks can be selected to play this sector in 2022, or an ETF approach can give an investor immediate diversification.
An unforeseen event -- such as the advent of the pandemic was in 2020 -- could derail any 2022 predictions. As a result, any stock picks made should be held for at least three years to ride out any market volatility. Tech has led the way for many years, and I see no reason to doubt that it will continue to.
