The technology sector was a strong market outperformer at the beginning of the COVID-19 pandemic and performed on par with the market in 2021, but this has evaporated in 2022. Further, mega-cap tech firms (Apple (AAPL), Microsoft (MSFT)) have held up relatively well, masking some of the carnage across smaller tech names.

Although macroeconomic concerns are on the top of investors minds, we still see strong underlying secular tailwinds in technology, such as cloud computing and semiconductor adoption. Technology is now 20% undervalued and 21% undervalued within software, where we often see moaty companies. We would point investors toward high-quality, wide-moat software names, such as Salesforce.com (CRM), ServiceNow (NOW), and Adobe (ADBE), among others.

Techs Performance Has Reverted to Match the Broader Market

- Source: Garner, IDC, Statista, Morningstar. Data as of June 14, 2022.

As of June 27, the Morningstar US Technology Index was down 12.6% on a trailing 12-month basis, a far cry from the 33% TTM performance just six months ago. By comparison, the U.S. equity market is down 11% on a TTM basis. Over the past quarter, tech underperformed the broader market, down 18.6% versus 14.2% for the U.S. equity market.

We See the Most Buying Opportunities in Software

- Source: Garner, IDC, Statista, Morningstar. Data as of June 14, 2022.

As of June 27, the median U.S. technology stock was 20% undervalued compared with 10% undervalued a quarter ago and a sharp reversal from a sector that was 14% overvalued as recently as nine months ago. Software remains the most attractive subsector, 20% undervalued. High-flying growth stocks from 2020 have crashed and many now trade well below our fair value estimates. Meanwhile, more mature, higher-quality software names now provide investors with an attractive margin of safety. The semiconductor sector is 22% undervalued, while hardware is 12% undervalued.

The Cloud Opportunity Is the Most Obvious Secular Theme in Software

- Source: Garner, IDC, Statista, Morningstar. Data as of June 14, 2022.

In software, IT departments have been focused on digital transformation, first from the secular shift to cloud computing and software as a service, followed by the coronavirus pandemic and the critical rush to implement remote working tools. We foresee enterprises using software to modernize all types of business processes, in turn leading to software industry growth at a low-double-digit CAGR.

Additionally, we see an ongoing data boom that not only bodes well for cloud computing, but database management systems, too. Traditional databases like Oracle's still have their place, but emerging beneficiaries will be companies like Snowflake and MongoDB, with premier data-lake, data-warehouse, and data-marketplace offerings.

The Explosion of Data, Including Database Management System Revenue, Should Not Slow Down

- Source: Garner, IDC, Statista, Morningstar. Data as of June 14, 2022.

Top Picks

Salesforce.com (CRM) Star Rating: Economic Moat Rating: Wide Fair Value Estimate: $305 Fair Value Uncertainty: Medium

We believe Salesforce.com represents one of best long-term growth stories in large-cap software because of its ever-expanding portfolio of complementary solutions that allow users to completely embrace their customers, thereby building relationships, strengthening retention, and driving revenue. In our view, Salesforce will benefit further from natural cross-selling among its clouds, upselling more robust features within product lines, pricing actions, international growth, and continued acquisitions, such as the recent deals for Slack and Tableau.

ServiceNow (NOW) Star Rating: Economic Moat Rating: Wide Fair Value Estimate: $700 Fair Value Uncertainty: Medium

ServiceNow excels at executing the land-and-expand strategy, and it continues to use its strength in workflow automation to penetrate existing customers more deeply in IT and more broadly with human resources, customer-service specific, and other back-office products. We expect both tiered offerings and vertical-specific versions to continue to provide a nice tailwind to revenue. We think ServiceNow has become a key partner in digital transformation, as shown in retention statistics, which remains at the elite level. Importantly, we are impressed with ServiceNow's excellent balance between strong and highly visible revenue growth and robust margins.

ASML Holding (ASML) Star Rating: Economic Moat Rating: Wide Fair Value Estimate: $800 Fair Value Uncertainty: Medium

ASML is one of our top semiconductor picks, thanks to the increasing adoption of extreme ultraviolet lithography at large chipmakers such as TSMC (TSM) and Intel (INTC) to support explosive chip demand. Although the firm's first-quarter outlook is negatively affected by supply chain constraints, we think ASML will outgrow the wafer fab equipment industry in 2022. With TSMC, Intel, and Samsung (SSNNF) all vying for process technology leadership, we expect ASML to be a primary beneficiary since it sells tools to all three chipmakers.

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For Tech Stocks, the Cloud Is the Silver Lining - Morningstar