Sticking With Technology Stocks: Quality Behind The Momentum

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Includes: IGM, IGN, IGV, IRBO, SOXX, XT
by: Christopher Dhanraj

Summary

We believe the information technology sector still offers investors significant growth potential in spite of recent volatility and investor uncertainty around the stage of the market cycle.

We favor the sector for four key reasons.

We highlight two key trends that investors should keep in mind.

Despite recent volatility, the technology sector has meaningfully outperformed the market in 2018. Investors are now wondering whether the gains can continue. We discuss why technology stocks have the potential to withstand near-term volatility and deliver long-term returns.

Key points:

  • We believe the information technology sector still offers investors significant growth potential in spite of recent volatility and investor uncertainty around the stage of the market cycle. We favor the sector for four key reasons:
    • Exceptional earnings growth: The technology sector is consistently posting both top-line and earnings growth against a robust macroeconomic backdrop.
    • Economy-wide tech investment: Companies within and beyond the sector are investing heavily in new technologies, a tailwind for technology companies.
    • Robust quality attributes: Although investors associate technology stocks with the momentum factor, their quality traits help them potentially withstand market volatility.
    • Reasonable valuations: Given the sector's earnings potential, tech actually appears to be priced in reasonable ranges compared to its history.
  • We highlight two key trends that investors should keep in mind:
    • Money is in motion: Over $14 billion of net flows to U.S. listed tech ETFs, the most of any single sector year to date, suggest that investors are willing to pay for the sector's earnings potential.
    • The landscape has changed: major changes to the grouping of tech companies within indexes highlights the importance of investors truly understanding what they own.

Performance overview

The technology sector has outperformed the broader market in 2018, by almost 7% on a total return basis, continuing 2017's strong gains.1 Software companies have outperformed even more significantly, beating the market by 13% year to date. Multimedia and networking companies were ahead earlier in the year before more recently falling into line, while semiconductors have had a bumpier ride: ahead of the market by as much as 10% twice this year before declining consistently since June to now be behind the S&P 500 by almost 6%.

Chart 1: Year to date total return difference: technology and subsectors vs. broad market

Chart 1: Year to date total return difference: technology and subsectors vs. broad market

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com. Sources: BlackRock, Bloomberg, October 19, 2018. Performance depicted is that of the S&P 500 Information Technology Sector Net Total Return Index, S&P North American Technology Software Total Return Index, S&P North American Technology Multimedia Networking Total Return Index, Philadelphia Stock Exchange Semiconductor Total Return Index and the S&P 500 Total Return Index.

Short and long-term reasons to stay the course

Earnings: The information technology sector has consistently delivered earnings growth in excess of the broad market since 2009 (see Chart 2). The last earnings season saw 92% of technology companies posting earnings beats, compared to the broad market's 83%,2 and the current one has begun with earnings growth in excess of 23%.3 The sector's revenues are also projected to outstrip the market in 2019: with sales growth of 7% versus 5.1% for all global stocks.4

Chart 2: Earnings per share growth, technology sector vs broad market (Rebased to 100, 1/1/1996 to 10/19/2018)

Chart 2: Earnings per share growth, technology sector vs broad market (Rebased to 100, 1/1/1996 to 10/19/2018)

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results. Index performance does not represent actual iShares Fund performance. For actual fund performance, please visit www.iShares.com or www.blackrock.com. Source: Bloomberg, as of October 19 2018. Earnings depicted are the 12 month trailing earnings per share of the S&P 500 Technology Sector and the S&P 500 Index, since January 1, 1996.

Valuations: Investors appear willing to pay a premium to the broad market for the expectation of high quality future growth. The sector currently trades at a premium of 3% above the broad market based on forward price to earnings ratios, well below its historical average closer to 12%.5 While not cheap, this is nowhere near the excessive valuations the sector was previously associated with (See Chart 3) and in our view, justified on the basis of the sector's macro backdrop, earnings momentum and quality attributes.

Investment: Longer term, the magnitude of capital expenditures within the technology sector as well as widespread spending on technology across other sectors is a powerful tailwind, in our view. Cross-sector IT spending is forecast to grow to $4.3 trillion by 20226 as companies across sectors such as healthcare, financials and materials invest heavily in new technologies to augment revenues, drive efficiencies, or both. As we noted in Going global with technology, this has implications not just for the U.S. but for emerging markets that benefit from capex spill-overs.

Disruption: In addition to investing in current technologies, the long-term implications of investing in disruptive technologies are another potential tailwind. Technologies such as artificial intelligence, robotics, cloud computing, autonomous vehicles and the internet of things are powering disruption across the economy (See: Investing in breakthroughs). We believe these forces result in the tech sector exhibiting a strong secular growth profile into the future.

Chart 3: Technology sector valuation premium to broad market, Based on Forward PE ratios 1/31/1990 to 10/19/2018

Chart 3: Technology sector valuation premium to broad market, Based on Forward PE ratios 1/31/1990 to 10/19/2018

Source: Bloomberg, as of October 19, 2018. Based on the forward price to earnings ratios of the S&P 500 Information Technology Index relative to the S&P 500 Index. Forward earnings calculated based on Bloomberg estimates.

Built tough: why quality matters

The episodes of volatility driven by tightening financial conditions and global trade tensions has put focus on the need to build resilience into portfolios this year. As investors fear greater market uncertainty on the horizon, they could bid up the prices of those securities which have better liquid asset cushions to withstand choppy economic conditions. The information technology sector has long been associated with "momentum" investing, i.e., trending stocks. However, technology also has desirable quality factor traits, exhibited by healthy balance sheets and significant cash holdings, even after considerable R&D spend and record-breaking share buybacks. In fact, the sector now has over five times as much cash and short-term investments at its disposal than it did at the time of the infamous 'dot-com bubble' of 2000.7 Over the past 10 years, tech companies have bolstered their cash positions at 89% greater rate than the S&P 500 (See Chart 4). Investors seeking to screen their tech exposures for factor attributes can use the Factor Box Tool.

Chart 4: Growth of Cash & Short Term Investments per share, Technology sector vs S&P 500 (10/30/2008 to 10/19/2018)

Chart 4: Growth of Cash & Short Term Investments per share, Information Technology sector vs S&P 500 (10/30/2008 to 10/19/2018)

Source: Bloomberg, as of October 19, 2018. Based on change in Cash & Short Term Investments per share for members of the S&P 500 Information Technology Index between 10/31/2008 to 10/19/2018.

Investor positioning

ETF investors have allocated funds to the technology sector with a high degree of conviction. The technology sector has received the majority of single sector ETP flows, with over $14 billion in inflows year to date (See Chart 5) - three times that of the next sector (Materials), and ahead of 2017's full year total of $13.4 bn with three months to go.8 Though inflows have reduced in recent months, there has been no material uptick in outflows, suggesting that investors are willing to hold on for the earnings potential and quality attributes of the sector, in spite of recent market volatility.

Chart 5: U.S. listed technology sector ETF flows ($m)

Chart 5: U.S. listed technology sector ETF flows ($ m)

Source: Flow data sourced from Markit and calculated by BlackRock, October 18, 2018. ETP groupings and categories are determined by BlackRock.

Sector changes: is your tech really tech?

Beginning in September of this year, the Global Industry Classification Standard (GICS®) changed, with the telecommunications sector broadened and renamed "Communication Services" to include some companies currently classified under the media and internet and direct marketing retail sub-groups, as well as some currently in the technology sector. The implementation of these changes will have major impacts on ETFs tracking technology indexes based on GICS. What investors believe is technology exposure may not be as they expect. For a guide to the impact of the upcoming changes on iShares ETFs, click here.

The bottom line

The technology sector has performed extraordinarily well in 2018. We favor the sector on the basis of continued earnings momentum, widespread cross-sector investment on technology, and the quality factor. Though October's selloff demonstrates that even tech is not immune to volatility, we believe that powerful secular drivers give it the potential for resilient growth in the long-term and maintain our overweight to the sector.

© 2018 BlackRock, Inc. All rights reserved.

1 Source: Bloomberg, as of October 19, 2018. Based on the return of the S&P 500 Information Technology Sector Net Total Return Index compared to the S&P 500 Total Return Index.

2 Source: Bloomberg, as of August 31, 2018.

3 Source: Bloomberg, as of October 19, 2018.

4 Source: BlackRock Investment Institute with data from Thomson Reuters, October 2018. Based on aggregate analyst forecasts for sales growth for 2019 for the MSCI All-Country World Index and MSCI All-Country World Technology Index.

5 Source: Bloomberg, as of October 19, 2018. Based on historical forward price to earnings ratios for the S&P 500 Information Technology Index relative to the S&P 500 Index.

6 Source: Gartner Market Databook, 4Q, 2017.

7 Source: Bloomberg, as of October 19, 2018. Based on Cash & Short Term Investments per share for members of the S&P 500 Information Technology Index.

8 Source: Flow data sourced from Markit and calculated by BlackRock, October 18, 2018. ETP groupings and categories are determined by BlackRock.


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This post originally appeared on iShares.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.