MARCH 2018

The case for technology in 2018

Jun 8, 2018
By BlackRock

Key Points

  • Technology stocks have been star performers of the recent past; responsible for almost 30% of the total gains of the S&P 500 Index over the past five years.1 Can the good times roll on?
  • The U.S. ETF Investment Strategy team examines the three reasons why technology is one of its top sector picks:
    • strong earnings momentum,
    • significant cash balances and
    • longer-term disruptive trends.

Investors flocked to the technology sector last year with tech posting a 38% return while the broader market gained 22%.2 In spite of the solid gains across the market, we remain overweight tech stocks this year for three reasons, detailed below.

1. Strong earnings momentum

We recently upgraded U.S. equities from neutral to overweight on the basis of significant earnings growth expectations driven by fiscal stimulus and an already-supportive macroeconomic environment.

Making up a quarter of the broad index,3 information technology is central to the U.S. market. The earnings thesis supporting our overweight to U.S. stocks equally applies to technology companies, and builds on the sector’s existing earnings momentum. This reporting season, 88% of IT companies in the S&P 500 index posted positive earnings surprises – the highest proportion of all the sectors – while recording 22.5% aggregate year-on-year earnings growth compared to the broader market index's 14.3%.4 This has translated into strong equity market performance year to date, as depicted below. (Notably, the other high-flying sector, consumer discretionary, also includes two tech-powered giants: Amazon and Netflix.)

Year to date total return and Q4 2017 earnings surprises

Year to date total return and Q4 2017 earnings surprises

Source: BlackRock, Bloomberg, as of Feb 22, 2018. Sector performance and earnings results represented are that of the S&P 500 Index GICS sectors. Earnings surprises refer to the percentage of companies in a sector beating analyst estimates during the most recent reporting season. 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.

2. Significant cash balances

Many established technology companies are cash rich, commanding strong balance sheet positions and ample investment firepower. For example, Apple, Microsoft and Alphabet each sit on excess of US$100 billion.

This offers a number of advantages. First, these companies potentially are insulated from the impact of rising interest rates, and may even benefit. As we recently noted, technology historically has been among the sectors the most insulated from yield curve shifts.

In addition, one of the consequences of the recent tax legislation is the prospect of companies repatriating cash back to the U.S. at favorable rates. This increases the potential for dividends, share buybacks or increased mergers and acquisition activity. At the same time, increasing capital expenditure or research & development (R&D) spending is supportive of the sector in the longer term. For example, Apple, has already announced plans to invest $30 billion in capital expenditures in the U.S. over the next five years as a result of the tax law change and its plan to repatriate its cash.5

Top 5 U.S. tech stocks by cash holdings

Top 5 U.S. tech stocks by cash holdings

Source: Bloomberg, November 2, 2017.

3. Investing in long-term trends

The impacts of technological disruption extend beyond the confines of old fashioned sector classifications. As we highlighted in October, investing in technology allows investors to tap into large scale, transformational shifts in the way entire industries operate – whether it be the growth of “big data,” cloud-based enterprise and infrastructure solutions, cyber security or the intrinsic importance of semiconductors. Additionally, the growth of online shopping is displacing traditional brick-and-mortar retail and could change the face of commercial real estate markets. These forces result in the tech sector exhibiting a strong secular growth profile and in our view, justify a premium in the form of higher valuations.

Investors can choose from a wide range of exposures to tech shares. There are index vehicles such as exchange traded funds that seek to track broad indexes, like the S&P North American Technology Sector Index, which includes large cap tech stalwarts such as the group known as “FAANG” – Facebook, Amazon, Apple, Netflix and Google (Alphabet) – as well as Microsoft. Alternatively, vehicles tracking more focused sub-indexes allow investors to target companies with network and cyber security business lines or a software focus. Investors seeking a more economically sensitive exposure may consider ETFs tracking a semiconductor index, providing access to the growth of companies that design, manufacture or distribute semiconductors – the vital components of many electronics and computer devices.

The chart below demonstrates the dispersion of outcomes across various technology-focused indexes over the past five years. The Philadelphia Stock Exchange Semiconductor Index has a higher beta to the S&P 500 Index than the other indexes listed.6

Five year cumulative return of technology indexes

Five year cumulative return of technology indexes

 

Source: Bloomberg, as of 3/5/18. 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.

Would tech by any other name smell as sweet?

It is important to recognize that the implications of tech investing span beyond old fashioned sector classifications — and these classifications are evolving to reflect the changing landscape. In late 2017, S&P Dow Jones Indices and MSCI Inc. announced that under the Global Industry Classification Standard (GICS®) structure, the telecommunications services sector will be 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 index providers announced in January 2018 that companies such as Facebook, Alphabet and Netflix will join the communications services sector and Alibaba and eBay will join the internet & direct marketing retail sub-industry under consumer discretionary. These changes will be implemented by September 28, 2018.7

Investor positioning

Technology has topped all other single sector flows in 2018, with $5.1 billion in net inflows year-to-date. Only financials come close, with $4.9 billion, a sign of investors continuing to exhibit a preference for cyclical sectors as highlighted in The case for financials in 2018.

Year to date global ETF asset flows ($m)

Year to date global ETF asset flows ($m)

Source: BlackRock Global Business Intelligence, Feb 22 2018. Flow data sourced from Markit and calculated by BlackRock. ETP groupings and categories are determined by BlackRock.

The bottom line

Earnings momentum, strong balance sheets and economy-wide transformational forces of innovation and disruption are likely to provide both cyclical and structural support for technology stocks in 2018. Investors seeking exposure to technological growth can benefit from taking a targeted approach to their sector definitions.

Director
Head of ETF Investment Strategy