Technology and Growth, Now at a Reasonable Price: Several ETFs to Consider

by: Morningstar

By Robert Goldsborough

Exchange-traded fund investors surveying the landscape by sector should find information technology more affordable than it has been in a long time. As such, investors who are interested in growth but at a reasonable price can consider several technology-themed ETFs. In this article, we take a look at what is going on in the technology space - particularly from a historic valuation standpoint - and discuss our favorite technology ETFs.

Valuation: Looks Attractive on a Relative Basis

On a price/earnings basis, the information-technology sector may not be the cheapest sector, but it is cheap relative to its growth. For example, the largest and most liquid tech ETF, the Technology Select Sector SPDR (NYSEARCA:XLK) trades at a P/E ratio of about 15.1. That P/E ratio is down more than any other sector since the market peak in October 2007, despite the fact that the Census Bureau data show that new orders for durable goods in tech are down just 8% - much less than the 18% drop in new orders for all durable goods. So, while new orders are down less in tech, the P/E ratio is down more. There are two ways to measure growth. We can look at actual growth in financial statement data over time, or we can consider analysts' forecasts of future growth. On an historical earnings growth basis, tech is the second-fastest-growing sector behind health care, while on a forecast basis, tech should grow faster than any other sector except for consumer discretionary. As such, we conclude that tech is relatively inexpensive while still offering above-market growth.

Today's Tech Landscape

Tech industry bellwethers Cisco Systems (NASDAQ:CSCO) and Oracle (NYSE:ORCL) took divergent paths in the fourth quarter of 2010. Cisco, while announcing strong earnings, issued a bearish outlook, and the stock was down 6% for the quarter. The firm blamed a weak public sector, particularly in Europe, and soft demand in the television set-top box market. On the other hand, Oracle was up 12%. As Morningstar senior stock analyst Michael Holt wrote in his Quarter-End Insights article, "Oracle's latest results provide perhaps the strongest evidence that IT spending will remain strong heading into 2011. With broad exposure to software and hardware markets across the globe, Oracle's performance is a barometer for a wide range of technology spending. The firm posted a 47% gain in sales from the prior-year period."

Pundits have bemoaned the slow demise of the Wintel duopoly of two tech titans, Intel (NASDAQ:INTC) and Microsoft (NASDAQ:MSFT). Intel has suffered from the rise of smartphones and other low-end computing devices, where low prices and energy efficiency are critical. Intel's chips are seen as expensive and energy hogs, and the company has lost ground to rival ARM Holdings (NASDAQ:ARMH), which now dominates that market. Microsoft recently announced that its next version of Windows would provide support for ARM-based chips. Meanwhile, Microsoft has faced competitive threats from Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), losing market share for Web browser software and falling behind in the mobile operating software market. In just two years, Microsoft's share of the browser market went from more than 70% to below 50%, by some estimates. But the decline in market dominance and reduced growth prospects already may be priced in both of the stocks. Back in October of 2007, Intel traded at a P/E of 24.2 while Microsoft traded at 22.0. Today, the stocks' P/E ratios are down to 11.5 and 12.7, respectively. According to Morningstar's analysts, both stocks trade at a lower price/fair value than the rest of the market while having wide economic moats, which is an indication of being high-quality companies.

Tech companies have a lot of cash on their balance sheets, and they have been putting it to work by acquiring other companies. Among major acquisitions over the past year, Hewlett-Packard Company (NYSE:HPQ) acquired storage-company 3PAR for $2.3 billion, or a 300% premium. HPQ also acquired Palm for $1 billion, giving it access to the Palm WebOS, in a clear attempt to stay relevant in the mobile computing industry. Just recently, Qualcomm announced a $3.1 billion deal to acquire Atheros Communications (NASDAQ:ATHR), a leading provider of Wi-Fi chips. Google made an unsuccessful bid to acquire Groupon, while Facebook struck a deal with Goldman Sachs (NYSE:GS) that allows Facebook to raise capital without breaching the 500-investor limit that trips greater public disclosure requirements.

Most recently, Apple, which is a large weighting in every tech ETF, announced that its CEO, Steve Jobs, would take another medical leave for an undisclosed reason, prompting shares to fall. Most Wall Street analysts continue to feel good about Apple's product pipeline and even about its management bench, however, and if anything, the pullback in Apple's shares immediately following the firm's announcement may represent a buying opportunity for ETF investors.

Small But Important Differences Among Tech ETFs

There are a number of ETFs that focus on technology stocks, from traditional sector funds such as XLK (0.21% expense ratio), Vanguard Information Technology ETF (NYSEARCA:VGT) (0.24% expense ratio) and iShares Dow Jones U.S. Technology (NYSEARCA:IYW) to Fidelity Nasdaq Composite Index Tracking (NASDAQ:ONEQ) (0.30% expense ratio) and PowerShares QQQ (QQQQ) (0.20% expense ratio), also known as the Cubes. The two latter funds are not pure sector funds, but they do heavily overweight technology stocks. While the Cubes contain just the largest 100 stocks in the Nasdaq and trim the weight on Microsoft, ONEQ contains all 2,000-plus stocks traded on the Nasdaq and follows a more traditional market-cap weighting.

We currently favor XLK, which trades at the highest discount to fair value of the five ETFs discussed. In addition, XLK has the highest percentage of assets invested in firms with economic moats (more than 90% of its assets).

We would point to small but important differences between the tech ETFs. First, XLK invests in several subsectors that the other ETFs don't, including diversified telecommunication services (12% of assets), communications equipment (11%), and wireless telecommunication services (1%). As a result, XLK has significant exposure to large telecom firms like top 10 holdings AT&T (NYSE:T) and Verizon (NYSE:VZ). The other three ETFs, by contrast, have much less exposure to telecom, and where they do, it chiefly is through telecom equipment makers, rather than through phone companies.

Meanwhile, the Vanguard ETF has a significant exposure to IT services companies like Visa (NYSE:V) and Accenture (NYSE:ACN). And the Cubes, with a 64% allocation to information-technology companies, also has non-trivial allocations to a variety of non-technology sectors, including consumer discretionary (15%-plus of assets), health care (12%-plus of assets) and even industrial companies (4% of assets). ONEQ, by contrast, has even less exposure to technology, which comprises 52% of the fund's assets. In ONEQ, consumer discretionary, health care (primarily biotech), financials and industrials represent approximately 15%, 13%, 7%, and 5% of assets, respectively.

In the end, investors should pay close attention to expense ratios, given the high levels of performance correlation between these funds. For example, the Cubes and ONEQ have displayed a near-perfect, 98% correlation, while XLK, IYW, and VGT all are almost perfectly correlated. And XLK and QQQQ show 98% correlation over the past three years, as well. As such, investors looking for the most pure-play exposure to tech probably are best off going with XLK, while investors who are open to owning a large helping of tech with some sides of other growth stocks probably should consider investing in QQQQ.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.