ASX tech stocks haven’t had the best start to 2021 but Morningstar thinks they’re still overvalued and a bigger correction could be coming.

You might recall last week Morningstar predicted energy as the only undervalued sector. In the same report it labelled all other stocks as overvalued but ASX tech stocks were singled out as the most overvalued.

The ASX 200 Information Technology Index dropped 12 per cent in the March quarter while the ASX 200 rose by 2 per cent.

While tech is still a solid performer in the last 12 months, this isn’t because the stocks themselves have seen a substantial benefit – at least to the degree their share price gains would suggest.

“We believe this has less to do with underlying earnings performance than macroeconomic factors,” it said.

“Although the global pandemic has driven an increase in working from home and associated increase in demand for technology hardware and software, the benefit to company earnings has been lower than share prices imply in many cases.”

It also notes this hype has spread into recent IPOs but one factor which has stalled this rally could also be the end of it.

“We expect rising interest rates to stall share price momentum and break this feedback loop,” it declared.

 

Are all ASX tech stocks overvalued?

In Morningstar’s opinion, no. It thinks some companies that aren’t as highly valued aren’t as vulnerable to a market crash.

“Technology stocks which were left behind in the 2020 rally like Technology One (ASX:TNE) and IRESS (ASX:IRE), have more favourable valuations so are less susceptible to share price weakness,” it said.

In relation to IRESS, Morningstar thinks its fair value is $11 – a 15 per cent premium to its share price now. It says investors are concerned about competition in the industry but Morningstar thinks they are too worried.

“Although relatively new financial planning software providers, such as Netwealth (ASX:NWL), are growing quickly, we still expect IRESS’ switching costs to protect its business and enable the company to grow as it adapts to the changing industry,” it said.

Another stock in a similar boat is Link (ASX:LNK) which runs financial administration systems. It is trading at a 25 per cent discount to Morningstar’s fair value and it notes investors are concerned about superannuation reforms that might hurt its business.

“We believe the market is being too short-term-focused in this regard. Around 70% of group revenue is recurring and should help ensure the company survives the COVID-19-related economic downturn,” it said.

But even some stocks that have gained in recent months aren’t doomed to crash.

“Many technology stocks, such as Xero (ASX:XRO), should still experience strong long- term underlying business growth,” Morningstar said.

As for IPOs, which it thinks will continue, Morningstar recommends investors do their homework not on hype but “realistic earnings expectations”.

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