Tech Stocks: Have We Hit a Bottom?

Could it be that technology stocks, down a blistering 40% from the October 2007 highs, could outperform going forward in a rapidly deteriorating economy?  While it hasn’t been pretty for most stocks in the last year there are a number of encouraging signs that technology equities may have reached a nadir (at least a temporary one.)

Since the technology stock bubble burst, most management teams were replaced, balance sheets were de-levered and growth in expenses were managed tightly which argues for more resilient technology share prices today than during the weakness seen during the oft mentioned “tech wreck” that started in 2000.

Short Term Factors

Fundamental Performance to Date

We have seen signs of resilience in business models for technology companies to date this quarter.  While the “real” economy has shown clear signs of sliding into retrograde as a result of a global credit contraction, technology fundamentals have shown solid relative performance.  Recently bellwethers Google and IBM positively surprised investors with their latest earnings results.  Although a small sample size these performances provide some sign that technology fundamentals are far more solid than the recent market action suggests. 

Seasonality = It’s Not Different This Time

The accompanying chart illustrates that investing in technology shares, as represented by the NASDAQ Composite tends to be a highly profitable endeavor between September and May.  As can be seen, the average return for technology during the last twenty years during this period has been approximately 12%, with sixteen positive occurrences and 4 negative occurrences.  While there are many legitimate concerns about the economy and corporate profits, much of this may already be factored in to today’s discounted share prices.  If history is any guide the recent weakness in tech shares may have provided an excellent opportunity to profit during the next few months. 

Long-Term Factors

Greater Regulation = Greater Long-Term Demand for Technology

Regulation is often considered the bane of a free market but it often represents opportunity to profit, particularly for the shares of technology companies. There can be no doubt that as a result of this episode of “Free Markets Gone Wild” that financial services companies will face far more restrictive regulation than at any time since the Great Depression.   Today’s technology enables regulators to monitor and analyze market action in real time and to take corrective action as needed. 

As can be seen under regulations promulgated earlier this decade, data retention requirements soared. Sarbanes-Oxley and Regulation FD (Fair Disclosure) are two recent examples of regulatory change increasing demand for information technology products and services. While unfortunate I would expect far more draconian regulations once the current mess is sorted out driving increased requirements for IT Services, data storage and protection.

Secular Trends

Unchanged are many of the secular trends that existed prior to the recent convulsion in the markets. While many of these trends are likely to slow through any downturn, the snapback in spending in these areas should occur sooner and with greater vigor than purely cyclical areas within technology. Listed below are a number of secular growth themes within technology.

• Virtualization – driving more efficient utilization of technology resources
• Data Storage – growth in the Internet and increasing regulation
• Clean Tech – driven by the need to diversify energy resource needs
• Outsourcing – greater efficiency per unit of labor, flexible labor force
• Video Games – New platforms, inexpensive source of entertainment
• Flat Panel Television – Forthcoming Digital TV transition, low penetration
• Internet – Increasing international usage, domestic broadband growth
• Globalization – An increasing percentage of technology goods and services are sold to geographies having the potential to grow much faster than the U.S. and Europe 
  

Balance Sheets = Financial Flexibility

Over the last decade most technology companies have gone through great pains to de-lever their balance sheets. This occurred because many of these same companies borrowed significant amounts of debt (much of it convertible into common stock) at the turn of the new millennium.  During the Internet bubble these firms anticipated rapid growth over the ensuing decade. With the popping of the technology bubble, fundamentals deteriorated meaningfully and many of these convertible bonds that were expected to be converted into common equity actually didn’t convert. This absence of conversion to equity caused significant cost to the issuers, both in unanticipated interest expense on the underlying bond and in the case of some of these securities requiring redemption by the issuer, later becoming known as “death-spiral” convertibles. Today most large technology companies have little or no debt and a significant cash hoard placing them in a far better position to weather this slowdown than during the 2001-2003 version. The best technology companies are likely to pounce on a variety of opportunities that surface during recession.

• Continued Investment: Strong technology companies have the capability during recessions to continue to invest in their businesses, gaining market share versus their weaker competitors. For those that continue to invest while their struggling competitors slash budgets the recovery is likely to be much more significant. More than any other sector, success for technology companies is defined by creative destruction, developing new products to replace the old. Missing a product cycle is deadly for technology firms, austerity measures currently being taken by the weaker competitors make it far more likely that they will miss the next product iteration, enabling rapid share gain by those firms capable of investing through the downturn.
• Dividend Increases: Although dividend yield tends not to be the focus for technology investors, the current downturn has created a fairly significant improvement in the yields offered by these companies. Balance sheets today provide a high level of comfort that these firms can at a minimum maintain, if not increase, current dividend levels. Many technology management teams have been reticent to pay dividends fearing that they will be “signaling” their company has reached maturity. I would expect the stigma attached with paying a dividend equating to slow growth will diffuse over time and an increasing percentage of technology companies will become yield bearing instruments.
• Buybacks: Stock buybacks have historically been the method of choice for technology companies returning capital to shareholders. I prefer dividends myself as dividends reward long term holders for retaining ownership of the company stock whereas buybacks tend to favor those shareholders who want to sell the companies stock, providing liquidity to the seller of the stock. That said I would expect a material increase in buyback activity at current levels from those firms that believe their share price has become undervalued, there are many.
• Acquisitions: The high cash levels and balance sheet flexibility will enable a rash of acquisitions for companies looking to solidify their competitive position in the market on the cheap. The forthcoming acquisition binge will be all the more powerful once the credit markets loosen up and enable a more capital efficient mix of debt to equity in such deals. Even without more favorable bond market conditions, opportunistic acquirers will be able to effect mergers through a mix of balance sheet cash and/or equity. Areas within technology that are ripe for acquisition activity are software, internet and semiconductor industries. In light of the recent market decline I would expect many of the deals will either have to be at significant premiums to current market prices in order to get the deal done, or go hostile.

Valuations = Too Cheap to ignore

With the eight largest technology companies in the Nasdaq 100 Index trading at 13x forward earnings and a 7.7% earnings yield the stocks are simply too cheap to ignore. 

Summary Thoughts

Shares of technology stocks have clearly seen better days and with earnings season about to start in earnest choppiness is likely to continue as shares reset to lowered expectations. That said there are some early signs that the worst may be behind us, the indiscriminant sell-off in recent weeks has created significant value in technology shares. For those with a 2-3 year time horizon I believe it makes a great deal of sense to consider accumulating shares of ETFs that focus on the technology sector such as QQQQ, or for a more aggressive levered exposure to tech shares the ProShares Ultra QQQ (QLD)  or Ultra Technology ProShares (ROM) ETFs may fit the bill.

Disclosure: Author holds positions in GOOG and ROM