Technology: Stock Strength Continued in the Third Quarter

Following a strong performance throughout 2024, the technology sector experienced a collapse in the first quarter and has been rebounding since early April. We view the sector as being slightly undervalued overall. Tech stocks began to rebound after the Trump administration introduced sweeping trade policy changes, including hefty tariffs. Hardware stocks have been strong throughout the year, while semiconductor stocks have been solid and software stocks have lagged.

Overall, tech was the second-strongest sector in the quarter, in a continued rebound from a weak first quarter, when it was the second-worst-performing sector. Over the past 12 months, tech’s performance has been above average and it is the second-best-performing sector, outperforming the market by more than 900 basis points. Our confidence in secular tailwinds, such as cloud computing, artificial intelligence, and the long-term expansion of semiconductor demand, remains unchanged. We see software as offering the most upside.

Generative AI remains the largest theme within the tech sector. Software firms are developing and incorporating next-generation AI capabilities into their solutions, while cloud providers are introducing new services and increasing capacity. Meanwhile, some semiconductor firms, such as Nvidia, are experiencing surging demand for AI and data center chip applications. We see attractive value within the AI theme as scarce.

The Morningstar US Technology Index is up 27% on a trailing 12-month basis, compared with the US equity market, which is up 17.5%, as shown in the top exhibit. The median US technology stock is slightly undervalued, whereas the average is fairly valued, with little margin of safety. We view hardware as overvalued, with semiconductors fairly valued, and software as undervalued, as shown in the bottom panel at the right.

We expect AI accelerator (AI chip) revenue will increase roughly four times over the next several years, making AI the most significant growth driver in the semiconductor industry. While Nvidia will lead this growth, we also see other chip vendors, such as Broadcom and Advanced Micro Devices, benefiting as well. We also expect AI to extend into the rest of the semiconductor value chain, with fabs, EDA software, IP, memory, and equipment firms experiencing outsize growth. That means firms like Taiwan Semiconductor, Synopsys, and ASML should also benefit from AI.

Top Technology Sector Picks

Atlassian

• Fair Value Estimate: $230.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: Narrow
• Morningstar Uncertainty Rating: High

Atlassian TEAM is a leading provider of project management and collaboration solutions for software developers and continues to do well with expansion into service management. The firm is emerging from a model transition to be primarily cloud-based, which was inevitable and leaves it better ablet to innovate and compete with larger peers. Atlassian’s broad portfolio helps establish a large base across clients of all sizes and gives the firm an opportunity to integrate AI throughout its growing portfolio. The firm is also investing in a salesforce to have more of a direct presence, which should further support topline growth efforts.

Microsoft

• Fair Value Estimate: $600.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: Medium

Microsoft MSFT is one of our top picks in the technology sector. The company dominates several of its served markets, such as with Office in productivity software and Windows for PC operating systems, and has also established itself as one of two clear leaders in public cloud. We think the proliferation of hybrid cloud environments will continue to strengthen Microsoft’s position with Azure. Further, the firm’s investment in OpenAI has catapulted Microsoft into a leadership position in generative AI, which has driven an acceleration of Azure growth in recent quarters. Our growth estimates are centered around Azure, Microsoft 365 E5 migration, traction with the Power Platform for long-term value creation, and proliferation of AI.

NXP Semiconductors

• Fair Value Estimate: $280.00
• Morningstar Rating: ★★★★
• Morningstar Economic Moat Rating: Wide
• Morningstar Uncertainty Rating: High

Wide-moat NXP NXPI is one of our top picks in semis. As automotive and industrial demand improves from cyclical and tariff softness, we anticipate that NXP will benefit from a recovery. We like NXP’s outsize exposure to autos, where it obtains nearly 50% of its revenue. NXP is well-diversified in autos with a broad portfolio of processors, microcontrollers, and analog parts. The firm should gain share in electrification and safety automotive products, too, such as radar and battery management systems. Overall, NXP’s auto business is well tied to the secular tailwinds around rising chip content per vehicle.