Why Technology Will Outperform The S&P 500 In The Long Run

by: Nicholas Pardini

One thing that the recent economic downturn has shown is the decline of the U.S. competitive advantage against the rest of the world across the economy from the labor market, to basic materials, to now even the financial sector. However, one place where America does hold a comparative advantage is the technology sector (NYSEARCA:XLK). In the long term I remain bullish on tech due to strong profitability, relatively easy expansion into emerging economies, and the continuing the trend of corporations moving towards automation to reduce costs.

Unlike other aspects of the economy that are at severe risk of contraction, the demand for IT is still growing and tech companies in a financially sound position to capitalize off this growth. In the recessionary years of 2008 and 2009, corporate IT spending grew at 2% annually while the rest of the economy contracted. Flushed with cash generated from cuts in labor costs and other expenses, major corporations continue to expand their spending in IT (on pace for 7.1% growth in 2011). The reason for this continued investment is that the gains in savings in automation (primarily through lower payrolls), vastly outpace the additional costs of more advanced computing systems. This trend is bad for employment, but is bullish for the tech sector. Consumer tech sales are still growing as well. According Gartner Research, tablet sales are to quadruple for the year, mobile devices are up 74%, and even the lagging PC sector is still growing at a 3.8% after bearish revisions.

The main obstacles in technology include the fast pace of obsolescence within the industry, the destruction of disposable income among Western consumers, and high betas of tech stocks causing a faster decline of prices versus the market during a panic a sell off. Obsolescence can happen quickly [as in the case of Research In Motion (RIMM)] and no assumed continuing value of a company is safe to creative destruction from a better product. However, this can be hedged by buying a sector ETF such as the XLK for the U.S. or IXN for more global exposure. These can also be broken down into industries such as software, Internet, or semiconductors stocks (click here for full list). The volatile nature of technology is also a product of creative destruction and also the discretionary nature of consumer electronics versus staples. However, I believe any decline in U.S. and European consumer sales in technology will be offset by spending in the corporate sector and in emerging markets.

Within the sector the best opportunities are companies that are involved in the automation in information sector, defense, and the consumer sector. Robotics companies such as iRobot (NASDAQ:IRBT) and Aerovironment (NASDAQ:AVAV) benefit from the need of the military to be more efficient by using machines to replace soldiers in the most costly and dangerous work on the battlefield. The growth of robotics will also establish a greater presence in the consumer and manufacturing sector as companies such as Foxconn (FXTCF.PK) are phasing out their workforce with machinery and domestic machines such as the Roomba are improving in quality. Other sectors in tech with strong prospects include the leading cloud computing companies such as Amazon (NASDAQ:AMZN) and VMWare (NYSE:VMW) as they continue to improve corporate efficiency at 16% plus profit margins along with semiconductors such as Intel (NASDAQ:INTC) and Altera (NASDAQ:ALTR) who offer 20%+ ROICs and make good value plays (Intel also has a high dividend yield).

Overall, despite a weakened economy, the tech sector has continued to perform well as earnings, cash reserves, and margins are among the highest in any industry of the market. Due to macro driven issues in the global economy, I do not recommend buying right now. However, once the macroeconomic dust settles, I expect this to show in stock prices when the fundamentals retake the driving seat in the market.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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