INVESTING

3 reasons to stick with tech stocks

Russ Koesterich, CFA, JD |Feb 21, 2020

Russ explains why it’s not yet time to sell those tech shares.

Technology shares are once again leaving everything else in the dust. Year-to-date, the MSCI Information Technology sector, led by U.S. tech, is beating the broader market by over 5% and is ahead of laggards, notably energy, by nearly 20% (see Chart 1).

Given the magnitude of the gains, many are understandably wondering if it’s time to sell. My simple answer: no.

I last wrote about technology and growth stocks in September. At the time I suggested that growth should continue to outperform.  Today, while the broader style and tech sector are vulnerable near-term, I would cite three reasons why outperformance should continue.

1. It’s all about the cash flow.

Based on traditional metrics, technology shares look expensive. The S&P 500 Technology Sector trades at approximately 23 times this year’s earnings (P/E). Looking at relative value – the P/E of the sector versus the broader market – the sector is trading at roughly a 22% premium, a level we have not seen in more than a decade. That said, the sector remains extraordinary profitable.  The return-on-equity is roughly 30%, seven percentage points above the 10-year average. Exceptional profitability has led to exceptional cash-flow generation, much of which is returned to shareholders in the form of buybacks. As a result, using price-to-cash flow (P/C), tech’s premium looks right in-line with the 10-year average.

2. Easy financial conditions help.

Another factor favoring technology is liquidity. Technology stocks are much more likely to outperform when liquidity is improving. Using the Goldman Sachs Financial Conditions Index as a proxy, rising liquidity has been associated with average monthly outperformance of about 1.5%. Conversely, the sector underperformed by an average of nearly 1% in months when financial conditions deteriorated. Perversely, the current environment of soft growth and hard-to-quantify growth shocks, i.e. the coronavirus, supports liquidity and by extension tech shares.

3. In a slow growth world, tech can be defensive.

Finally, and most surprisingly, tech is not the same “high beta” play it was in the 1990s. Between 1995 and the end of the financial crisis, tech typically underperformed by roughly 0.10% for every 1% rise in market volatility, measured by the VIX Index. That pattern no longer holds. Today, when rising volatility is met with a policy response, as it tends to be, technology is more likely to outperform. Since 2010, in months when volatility rose and financial conditions eased, the median relative return for technology was + 0.38%. This change in fortune is arguably a function of big, long-term trends. Regardless of the quarter-to-quarter shifts in the economy, investors have confidence that secular themes –cloud computing, AI or internet retail – support tech earnings.

None of the above means that technology is not vulnerable to a short-term correction. That said, looking out over the next year technology stocks are still likely to have the wind at their back, even if things get a bit rougher.

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