Technology has been the stand-out sector this year, rising 38% year-to-date versus a 16% gain for the S&P 500, outperforming other sectors by the widest margin since the 2000s dot-com peak.
Much of the outperformance comes down to a handful of stocks, with Alphabet and Facebook accounting for nearly 20% of the sector’s market capitalization. Some investors may see risks in the pace of the advance and its apparent concentration in just a few stocks.
But we believe the case for tech remains compelling:
- Profit growth continues to outperform across the whole sector. Of the tech companies that have reported, more than 90% have beaten EPS estimates and by an aggregate 12%. For the third quarter in a row, US tech earnings will rise by 20%.
- Valuations look affordable. The sector’s price-to-earnings ratio is just 7% higher than the broader US market, versus a 25-year average relative valuation premium of 22%. Since 1989, when the IT sector's P/E traded between 15x to 20x (it is currently 19.3x), the median 12-month-forward return has been 15%
- The sector offers a free-cash-flow yield of 4.7%, roughly 25 basis points above the S&P 500's earnings yield. Tech firms hold the largest offshore cash holdings of any sector, and will benefit if proposed tax reforms bring more favorable tax rates on repatriated profits.
So we continue to prefer US tech stocks, given the compelling secular growth outlook from drivers like cloud computing, cyber security and e-commerce. Valuations remain undemanding, the cyclical outlook is positive, and progress on tax reforms add to the prospects for further shareholder cash distributions.
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