Tech stocks were the stars of 2009's rally, but they endured a tough first couple of months in 2010. While they are still lagging the overall market, it looks like the correction they endured is over, with the SPDR for the sector (XLK) breaking its high from September 2008 this week after pulling back 11% from its high in early January to its low in early February:
Amazingly, the sector has recovered 71% of its losses during the bear market. While Technology stood out for all of 2009, most of the relative advantage occurred in the first half of the year. You can see in the chart above that that Tech stocks held their November lows in March as the rest of the market collapsed to new lows. In fact, since the end of Q2-09, Tech stocks have moved precisely in tandem with the overall market, though there was a burst of outperformance at year-end followed by the recent underperformance early in the year.
It appears that Technology stocks are in the middle of a very sustainable rally rather than near the end as some observers have suggested. I started the year with no exposure to the sector, but I have added several small-cap names to the Top 20 Model Portfolio, which is off to an excellent start relative to the market this year, as well as Texas Instruments (TXN) two weeks ago to the Conservative Growth/Balanced Model Portfolio. While I don't find it as compelling to load the boat on the sector as I do with small-cap Industrials, I am finding lots of opportunities worth investigating, especially in the large-caps. Here's what I am seeing:
Fundamentals
The sector benefits from many trends - outsourcing, automation, productivity, growth in the Internet and wireless, etc.. Importantly, the sector is highly exposed to economies beyond just ours. Absent gyrations in the value of the dollar against foreign currencies (one of the reasons for the pounding in January), this should increase demand compared to sectors more domestically-focused (like Consumer Discretionary). While access to capital is improving, the fact that the Technology sector exhibits the best balance sheets of any sector should still be a favorable factor. These companies can consolidate their industries, grow dividends (more later) or repurchase stock more easily than companies from other sectors generally. Tech revenues (and earnings) fell less than expected in the downturn, and it appears that the recovery is on solid ground.
Technicals
I don't have too much more to add in this area, but I do think it bears repeating: The sector just took out its September 2008 highs. Next up is the last stop before potential new post-2000 highs: The May 2008 highs. It's not that far from here at all: 25.69 compared to the close at 23.73 (8%). While XLK is modestly overbought, it is less so than it was for most of 2009. A final point I would offer is that Technology is 19% of the S&P 500. While it is the largest of the 10 sectors, its weighting is by no means extreme. If I recall, it was 45% back in 2000. Thus, while the liklihood of the sector continuing to rally at the same rate over the next year as it did over the past year doesn't seem high, the trends still look favorable.
Valuation
I saved valuation for last, because it is the most compelling aspect to the story. I don't care about valuation when the fundamentals and technicals are poor, but it's the most interesting piece of the puzzle when those other two factors are favorable. Let's face it: We have come a very long way in the past 10 years in terms of sentiment. What folks were willing to pay in 2000 for tech stocks was obscene, but, if you recall, it was rationalized at the time. It wasn't until the bubble burst that it became so obvious. We appear to be looking in a mirror now, as the valuations seem irrationally low. While I like to spend my time discovering small-caps with little following and huge potential, I find myself increasingly drawn to the names we all know so well but perhaps find too unexciting. I am talking about basically everything but Apple (AAPL), but even AAPL at less than 20 PE isn't outrageously expensive. Take a look at the top 16 (of 74) Tech names (greater than $30 billion) in the S&P 500 by market cap:
Given the typically high cash net of debt for these companies, the PE ratio actually overstates reality to some degree. Notice, though, that for these top Tech stocks, the forward PE is below that of the S&P 500. While for the broad market, the PE ratio is at a slight premium to its 10yr median (justifiably, perhaps, if one presumes that we are early cycle and that rates are lower than normal but likely to remain so), these stocks are trading at a discount to historical valuation. What is going on?
- The PE numbers are bogus because the estimates are wrong
- The rest of the market is going to grow so much faster than expected
- Big opportunity
I will will go with number three. I think that there is perhaps a lot of skepticism about the growth potential for these companies, in fact too much. It won't take much for companies like TXN, INTC, CSCO, AAPL, MSFT, and several others to make all-time-high earnings this year. The market is acting like these are peak earnings, with a downturn ahead, but I don't see it that way. In any event, it's pretty clear that if these companies can hit their numbers, valuation certainly isn't a constraint.
Here's another interesting valuation metric: The sector pays a dividend now that is over 50% of the market dividend. It wasn't that long ago that most stocks didn't pay a dividend. Now, though, despite typically low payout ratios, it isn't hard to find Tech stocks in the S&P 500 that pay dividends above the S&P 500. In fact, currently 11 make that cut: Analog Devices (ADI), Applied Materials (AMAT), Automatic Data Processing (ADP), Intel (INTC), Linear Technology (LLTC), Microchip (MCHP), Molex (MOLX), National Semi (NSM), Paychex (PAYX), Texas Instruments (TXN) and Xilinx (XLNX). Bears will see this as a sign of slowing growth and diminishing opportunities, but I think it reflects a wealth of excess capital and a propensity to crank out free cashflow.
So, don't sign me up for NASDAQ 5000 anytime soon, but I am relatively bullish on the Tech sector. As I mentioned, I have found some smaller names that I find quite interesting as well as TXN. The smaller names are focused on trends like smart phones, digital billboards and e-commerce transactions, all of which I expect to see a lot more abundantly in the future. So, growth and value, a nice combination...
Disclosure: Long TXN in a portfolio I manage as well as the Conservative Growth/Balanced Model Portfolio
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