By Kent Hargis, Chris Marx and Sammy Suzuki
Technology stocks are widely seen as powerful return drivers - with a lot of volatility attached. But surprisingly, shares of many companies that enable the technology revolution can provide solid returns and even downside protection.
It's been a volatile year for technology and new media stocks amid controversy at Facebook (NASDAQ:FB) and concerns about Amazon's (NASDAQ:AMZN) dominance. While the so-called FAANG stocks (Facebook, Amazon, Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX) and Google (GOOG, GOOGL)*) have delivered big gains in recent years, the associated risks have fueled anxiety about the entire sector.
Technology Enablers Have Resilient Businesses
Blanket fears about technology are off the mark, in our view. In fact, the sector includes many companies with solid business models, driven by long-term technological trends that don't face the same risks as the mega-caps do. It might sound counterintuitive, but we believe technology stocks with the right attributes can actually help protect a portfolio against spikes of market volatility.
These companies are not household names like Facebook and Google. But many supply the sophisticated plumbing that enables the internet-driven magic of modern life, which supports recurring revenue streams as technology spreads globally. They operate behind the scenes and may not have consumer-facing brands. As a result, these companies aren't in the cross-hairs of politicians or regulators, and are unlikely to be hurt by imposed changes to the industry structure.
What kind of technology companies fit the defensive bill? Think about companies that create enterprise software for banks that enable online transactions or process credit card purchases. Other examples include internet companies that help you make travel plans or keep track of your cell phone usage.
Looking beyond the FAANGs is a starting point to understand how some technology stocks can be defensive. The next step is to assess the sector for companies that offer quality and stability, and trade at attractive prices, which we believe are the three key components of downside protection.
Quality: High Profitability and Cash Positions
Many technology groups, especially in software, operate with low asset intensity and high profit margins. First movers with new technologies can secure a big advantage in niche businesses, which drive predictable, long-term profit streams. This helps foster strong cash positions - a vital ingredient for downside protection, especially in a rising-interest rate environment.
Our research shows that technology companies across developed markets have net cash in aggregate. In contrast, traditional safe havens in equity markets, such as utilities, real estate and consumer staples companies, are highly sensitive to interest rates, owing to high dividend payout ratios, relatively slow growth rates and an income-like nature that makes them behave like bond proxies. What's more, these companies also have higher debt burdens, which add to the risks. In our view, the dearth of debt in the technology industry provides an important buffer against rising interest rates and should support equity returns in a more challenging environment.
Stability: Pockets of Lower Beta
But aren't technology stocks volatile? There is some truth to this stereotype. Technology stocks generally exhibit high beta, which suggests that they're riskier. The global technology sector in the MSCI World Index had a beta of 1.2 at the end of April (Display, left).
Yet, the sector isn't uniform. About 26% of MSCI World technology stocks have a beta lower than 1.0 (Display, right), meaning their trading patterns are less volatile than the market is. So investors have plenty of options to find stability in technology stocks.
Price: Cheaper than You Think
Valuation is the third component of our search for downside protection. The protective qualities of high-quality companies with stable trading patterns can easily be undermined if a stock is too expensive. Today, shares of some companies in traditional defensive sectors are pricey. And mega-cap technology stocks are not cheap.
But plenty of technology stocks are attractively valued. Excluding Apple, Google and Facebook, the equally weighted price-to-forward earnings ratio of technology stocks was 18.0 at the end of April - about 35% lower than was the valuation of the FAANGs (Display, left). Non-FAANG technology stocks are also much cheaper on a price-to-cash flow basis.
Combining attractive valuation and stability is a winning recipe for defense, in our view. Our research shows that during downturns over the past five years, low-beta technology stocks fell less than the market did, capturing only 86% of the declines (Display, right). And in rising markets, low-volatility technology stocks rose more than the market did, capturing 126% of the gains - almost as much as the broader technology sector.
Reducing Losses with Tech Stocks
Finding stocks that fall less than the market does during downturns is a cornerstone of a defensive strategy, in our view. Reducing losses can help a portfolio recover faster when a rebound materializes. Traditional defensive sectors may not do the job today, as they are relatively expensive and highly sensitive to interest rates.
Securing downside protection requires creative thinking about the underlying characteristics of individual stocks. Don't let the headlines about Facebook divert your attention from shares of technology enablers, which could help protect a portfolio from market volatility and provide solid long-term potential with a smoother pattern of returns.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio management teams.
*Facebook, Apple and Google (Alphabet Inc.) are classified as technology stocks by GICS. Amazon and Netflix are classified as consumer discretionary stocks.