Technology Distributors: Lazy but Smart Way to Invest in the Sector

Includes: ARW, AVT, IM, SNX, TECD
by: Alan Brochstein, CFA

Were it not for Energy, which is up a stunning 14.4% YTD, Technology would be leading the way (up 5.73%) among sectors in the S&P 500.

After sitting out most of 2010 following a huge 2009, it looks like sector, as depicted by the SPDR Technology ETF (NYSEARCA:XLK) is in an uptrend again (click to enlarge images):

The sector, which is by far the largest in the S&P 500 at 18.6%, has many traits that have helped it to have among the highest returns among the 10 sectors over the past several years, including strong balance sheets and high exposure to non-U.S. markets compared to other sectors.

While I believe that the sector generally has similar fundamental drivers as the Industrials sector, investors are paying up more for Industrials as evidenced by the 15.8 2011 PE for Industrials and a market-matching 13.8 2011 PE for Technology (according to S&P data). This is a far cry from a decade ago, when it seemed like Tech stocks traded at 13.8X as well, only we were talking about sales rather than earnings.

If you agree with me that Technology seems attractive, there are many choices. I have been migrating my Top 20 Model Portfolio into the sector over the past several months, and it is now my largest (31%), passing up Industrials (where my focus is on smaller companies). While I have spread my bets among six very different names, including two mega caps (I like mega caps), one that we added late in 2010 is leading the way, distributor TechData (NASDAQ:TECD).

So, while I could (and might soon) share more specifically about the one that I selected, I want to discuss the broader concept of investing in a distributor to capture the expected growth in an industry. Generally, distributors are a bet on the industry's fortunes. They allow investors to get broad exposure through a single company (kind of like an ETF, but with a major distinction: It's an operating company).

Distributors tend to carry many products from small to large manufacturers and sell them to all but the largest customers of those companies (who often, but not always, are efficiently served directly). Distributors work on relatively thin margins and thus have very low P/S ratios typically. Investing in distributors requires the investor to have an understanding of how the distributor differs from the general industry in terms of exposures to vendors and customers, but also an understanding of the dynamics among its competition.

The technology distributors I will discuss all enjoy a relatively high amount of consolidation - just a few distributors are able to handle most of the volume. Within technology, there are two sets of distributors (with a little overlap): Broadline and Semiconductors. The Broadline distributors include Ingram Micro (NYSE:IM), Synnex (NYSE:SNX) and TechData (TECD), while Arrow (NYSE:ARW) and Avnet (NYSE:AVT) comprise the major semiconductor distributors.

Here is some big-picture data:

What we see is that these mid caps trade below 10 PE but are experiencing double-digit growth in 2011 and expected to grow next year as well. IM and TECD jump out as the cheapest to me, especially when I factor in the cash in excess of debt for both of them.

What really strikes me is how much investors are willing to pay for other distributors. I have long followed the Healthcare distributors, and they trade at much higher valuations.

Here is the same table as before, but with healthcare distributors, an industrial distributor and a food distributor:

It seems to me that investors are either paying too much for other distributors or seriously undervaluing the Technology Distributors. Often a lower PE is a function of worse balance sheets or diminished earnings expectations, but neither appears to be the case here. I have long followed TECD and Cardinal Health (NYSE:CAH), and the current relationship strikes me as odd. I shared the following chart last week with my subscribers at My Own Analyst that demonstrates how out of whack the relationship is:

It's a little difficult to read, but the bottom panel illustrates the historical relationship between the valuations of the two companies.

It looks to me like these stocks are working already, but the upside may be significantly greater than the typical stock given how inexpensive the stocks currently are. Maybe it pays to find a stock in the sector that can outperform, and maybe it makes sense to just go with XLK, but it strikes me as a lazy but smart way to invest in technology by just going with a distributor.

Disclosure: TECD is in the Top 20 Model Portfolio at Invest By Model, while OMI is in the Conservative Growth/Balanced Model