US technology sector funds saw their largest inflows in more than eight months last week, adding to the 30% year-to-date rise in the S&P tech sector index. Such enthusiasm raises concerns that the technology trade is becoming crowded.
But there are reasons why we believe that the sector remains attractive:
- Tech valuations still look modest. The sector is currently trading at a price-earnings ratio that is 4% higher than the US market, versus its relative average valuation premium of 22% over the last 25 years. This lower-than-normal valuation appears unjustified, given strong corporate demand for enterprise technology. Since 1989, when the IT sector's P/E traded between 15x to 20x (it is currently 18.7x), the median 12-month-forward return has been 15%.
- The sector is returning cash to shareholders, and would likely be a big beneficiary of a Republican tax cut. The sector's free-cash-flow yield of 5% is 40 basis points above the S&P 500 index yield. Tech companies are aggressively returning this cash flow to shareholders. The sector has a total yield (share buybacks and dividends) of 3.7%. With the largest overseas cash holdings of any sector, tech would be the biggest beneficiaries of tax relief on the repatriation of overseas profits.
- Profit growth remains robust. Although the third-quarter earnings season has just begun, 91% of all tech companies that have reported results have beaten earnings growth forecasts of 8.8% as of 20 October.
So we still prefer US tech stocks given solid long-term earnings growth prospects, aggressive cash distributions to shareholders, and a renewed optimism over tax cuts.
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