After a lackluster first half of 2016, the technology sector is on fire in the third quarter on improving fundamentals, investors' drive for cheaper valuation and renewed focus on beaten down growth stocks. In fact, the sector led the market rally in Q3, with the ultra-popular Select Sector SPDR Technology ETF (NYSEARCA:XLK) gaining nearly 10.5% versus the gain of 3.4% for SPDR S&P 500 (NYSEARCA:SPY).
Inside the Surge
Impressive growth of the sector largely hinges on Apple's (NASDAQ:AAPL) solid performance led by robust earnings and the iPhone 7 launch. The flurry of better-than-expected Q2 results from heavyweights such as Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN) and Facebook (NASDAQ:FB) also injected optimism, pushing the sector to new highs. Ongoing consolidation in the semiconductor industry and strong earnings reports from chipmakers Intel (NASDAQ:INTC), Qualcomm (NASDAQ:QCOM), Texas Instrument (NYSE:TXN) and Nvidia (NASDAQ:NVDA) added further strength.
In fact, the sector has staged a strong turnaround from the two previous quarters of negative earnings and even surpassed the S&P 500. The trend is likely to continue in the third quarter as the sector's earnings are expected to decline 1.9%, much lower than that of the S&P 500's decline of 3.1%, as per the Earnings Trend report. The expectation of outperformance in Q3 continues to fuel the rally in the sector.
Additionally, a strengthening economy and better job prospects gave a nice boost to economically sensitive growth sectors like technology that typically perform well in a maturing economic cycle.
As the world is becoming increasingly digital, demand for novel and advanced technologies such as cloud computing, big data, smartphones, high-speed fiber networks and the Internet of Things is growing by leaps and bounds. This is creating great opportunities for tech companies. And not to forget, most of these tech companies are sitting on a huge pile of cash and are in a position to increase payouts to their shareholders. The cash reserves will ensure that these companies are not plagued by financial trouble even in a rising interest rate environment, the chance of which is looming large for later this year.
While most of the ETFs and stocks have outperformed in Q3, we have highlighted four from each corner of the space that will continue their outperformance in the coming months as well:
Using our database, we have selected those technology ETFs that offer domestic exposure and have a Zacks Rank #1 (Strong Buy), 2 (Buy) or 3 (Hold). Each of these has the potential to move higher in Q4 as well.
PowerShares Dynamic Networking Portfolio (NYSEARCA:PXQ) - Up 22.6%
This product targets the networking segment of the broad U.S. technology sector by tracking the Dynamic Networking Intellidex Index. Holding 30 securities in its basket, the fund is well spread across each component as each security accounts for less than 5.1% share in the basket. From an industrial look, about half of the portfolio is focused on communication equipment followed by 30% in software and programming. The fund is unpopular and illiquid in the broad tech space with AUM of $19.9 million and average daily volume of about 3,000 shares. It charges 63 bps in annual fees and has a Zacks ETF Rank of 1 with a High risk outlook.
Global X Social Media Index ETF (NASDAQ:SOCL) - Up 21.7%
This fund provides pure play access to social media companies around the world and follows the Solactive Social Media Total Return Index. It has amassed $132 million in its asset base and charges 0.65% in fees and expenses. The ETF sees a lower trading volumes of roughly 48,000 shares a day. In total, it holds 31 securities in the basket with higher concentration on the top four firms making up for a combined 39% share. U.S. firms take half of the portfolio, closely followed by China (26%), Japan (8%) and Russia (6%). The fund has a Zacks ETF Rank of 3, with a High risk outlook.
PowerShares Dynamic Semiconductors Fund (NYSEARCA:PSI) - Up 21.5%
This ETF provides exposure to the semiconductor segment of the broader U.S. technology sector by tracking the Dynamic Semiconductor Intellidex Index. This benchmark selects stocks on a variety of investment criteria: price momentum, earnings momentum, quality, management action and value. In total, the fund holds a small basket of 30 securities with none holding more than 5.2% share. The product, with AUM of $92.7 million is often overlooked by investors and hence sees a lower average daily volume of around 23,000 shares. The product charges a fee of 63 bps a year and has a Zacks ETF Rank of 1, with a High risk outlook.
Market Vectors Semiconductor ETF (NYSEARCA:SMH) - Up 18.3%
This fund provides exposure to 26 chipmakers by tracking the MVIS US Listed Semiconductor 25 Index. It has a large concentration on the top two firms that collectively make up for 26.1% of assets. The product has managed assets worth $567.4 million and charges 35 bps in annual fees and expenses. It is heavily traded with volume of around 2.7 million shares per day and has a Zacks ETF Rank of 2, with a High risk outlook.
To pick the best performing stocks in the sector, we have used the Zacks Stock Screener. We narrowed down the list by selecting stocks with a Zacks Rank #1 or #2, a VGM Style Score of A or B, and market cap of above $2 billion. Investors should note that these stocks have the potential to continue their outperformance next year.
Lumentum Holdings Inc. (NASDAQ:LITE) - Up 73.3%
Based in Milpitas, California, Lumentum is a manufacturer of innovative optical and photonic products in the Americas, the Asia-Pacific, Europe, the Middle East and Africa. The company delivered a positive earnings surprise of 24.5% in three of the last four quarters, with current year earnings expected to grow 61.5%, much higher than the industry average growth of 5%. The stock has a Zacks Rank #1 with a VGM Score of B and a market cap of $2.46 billion.
Finisar Corp. (NASDAQ:FNSR) - Up 68.5%
Based in Sunnyvale, California, Finisar is the world's largest supplier of optical subsystems and components for data communication and telecommunication applications in the United States, Malaysia, China and internationally. The stock delivered positive earnings surprises in the last four quarters, with an average beat of 35.7%. The current earnings estimate for fiscal 2016 represents a whopping growth of 143.9%. FNSR has a Zacks Rank #1 with a VGM Style Score of B and market cap of $3.21 billion.
InterDigital Inc. (NASDAQ:IDCC) - Up 40.6%
Based in Wilmington, Delaware, InterDigital designs and develops technologies that enable and enhance wireless communications in the United States and internationally. The company came up with an average positive earnings surprise of 82.43% for the past four quarters. Earnings are expected to grow at 74.1% in the current fiscal year compared with the industry average of -4.81%. The stock has a Zacks Rank #1 with a VGM Style Score of B and market cap of $2.65 billion.
Itron Inc. (NASDAQ:ITRI) - Up 26.8%
Based in Liberty Lake, Washington, Itron is a provider of metering solutions to electricity, gas, and water utility markets worldwide. The company delivered positive earnings surprises in three of the past four quarters, with an average beat of 16.36%. The current earnings estimate for 2016 represents a staggering growth of 218.8% versus the industry average of 3.8%. The stock has a Zacks Rank #1 with a VGM Style Score of A and market cap of $2.10 billion.