Tech Growth Worse, Value Better

9/2/2013


Investors expect technology stocks to deliver more profit growth than other stocks. Which probably explains why the sector has lagged the market over the last year.

Per-share profits for the S&P 1500 Technology Sector Index fell nearly 3% in the last year, seventh-worst among the 12 sectors, and the average stock in the sector posted 1% profit growth. As the table below illustrates, the technology sector has set the profit-growth pace for most of the last decade.

TWO SIDES OF TECH
Over the last 10 years, the S&P 1500 Technology Sector Index delivered annualized per-share-profit growth of 20.5%, tops among the index's ten sectors. Tech delivered middling sales growth and a decline in profits over the last year. The sector's price/earnings ratio is currently the fourth-cheapest among the 10 sectors.
Per-Share-Profit
Growth, Trailing
------ 12 Months ------
Sales Growth,
-- Trailing 12 Months --
Growth . . .
Absolute
(%)
Sector
Rank
Absolute
(%)
Sector
Rank
Last 12 Months
(2.6)
7
3.7
5
5 Yrs. Annual. (Through Second Quarter 2013)
10.7
3
5.1
3
Prev. 5 Yrs. Annual. (Through 2nd Qtr. 2008)
31.2
1
10.8
2
10 Yrs. Annual. (Through Second Quarter 2013)
20.5
1
7.9
3
. . . and value
Price/
Earnings
Ratio
Sector
Rank
Price/
Sales
Ratio
Sector
Rank
Current
16.5
4
2.2
10
% Of Months With Lower Valuation
33
1
50
3
Premium To 5-Yr. Median (%)
6
2
6
2
1-Year Median (Through July 2013)
15.7
3
2.1
10
5-Year Median (Through July 2013)
15.6
7
2.1
10
Previous 5-Year Median (Through July 2008)
23.8
10
2.4
10
10-Year Median (Through July 2013)
21.2
10
2.2
10

Given the slowdown, tech stocks' relative weakness over the last 12 months shouldn't surprise us. While the tech sector index managed 8.1% annual returns over the last five years, topping the broader index's 7.5%, tech's 5.5% return over the last year lagged the S&P 1500 by more than 130 percentage points.

Today's tech stocks look like better values than usual. We won't call them cheap, as they average Quadrix Value scores of 51. But the sector's price/earnings ratio of 16.5 is lower than 67% of the month-ends in the last decade. The tech index trades 6% above its five-year median price/earnings and price/sales ratios; most sector indexes command a higher premium.

However, the average technology stock in the S&P 1500 trades at 21 times trailing earnings. Most of the discrepancy between the valuation of the capitalization-weighted index and the average stock stems from a few giants with unusually low valuations, as discussed below.


Biggest stocks spoiling the fun

Why does the capitalization-weighted S&P 1500 Technology Sector Index trade at 16.5 times trailing earnings while the average tech stock sports a P/E of 21? Blame it on a few big party poopers.

As a group, larger stocks average lower P/E ratios than smaller stocks. But in a cap-weighted index, a small number of giants can have an outsized effect. Of the 266 technology stocks in the S&P 1500 Index, only nine have stock-market values above $100 billion.

Of those nine stocks, six — Apple ($489; AAPL), Cisco Systems ($23; CSCO), IBM ($183; IBM), Intel ($22; INTC), Microsoft ($33; MSFT), and Oracle ($32; ORCL) — trade at less than 13 times earnings.

Those six titans combine to account for more than 40% of the sector's market value and 56% of its earnings. Excluding the six stocks, the sector's trailing P/E ratio rises to 20.

Large laggards also weighed on the index's growth rate. Apple, Microsoft, and Intel combined to generate about a third of the index's profits over the last year, and as a group their profits fell nearly 8%. Those three big losers accounted for virtually all of the index's profit decline over the last year.


Industry and size

The largest tech stocks, with stock-market values above $10 billion, look the most attractive. They average substantially higher Quadrix scores for Value (59), Overall (67), and Reranked Overall (63) than small tech stocks, as well as substantially lower P/E ratios. Midcaps, with market values between $3 billion and $10 billion, lag their larger cousins' Quadrix scores but top the smallest stocks. While both large-cap and midcap stocks delivered higher profit growth over the last three years than smaller stocks, midcaps set the pace.

Within the tech sector, we find the best values in the IT services and computers & peripherals groups, while software companies average the highest profit growth over the last year. Semiconductor and semi equipment stocks deliver an unpleasant mix of slow growth and low Value scores.

For growth, valuation, and Quadrix information on all 266 S&P 1500 tech stocks, visit www.DowTheory.com/Go/Tech1. 

While tech stocks' average Overall score of 54 isn't impressive, we still find a number of companies with investment appeal, such as those in the table below and reviewed in the following paragraphs.

It's easy to dismiss a stock trading at more than 21 times trailing earnings as too expensive. Don't make that mistake with Alliance Data Systems ($196; ADS). In each of the last 15 quarters, Alliance has managed sales and per-share-profit growth of at least 7.5%. Only 13 companies in the S&P 1500 Index have matched that streak, and such reliability warrants an above-market valuation. At 16 times projected 2014 earnings, Alliance commands an 8% premium to the median S&P 1500 tech stock. However, Alliance trades at a 24% discount to the sector relative to trailing operating cash flow; the company's cash from operations nearly triples net income because of high noncash expenses.

Alliance's valuation seems reasonable considering its growth potential. Its two largest business units posted operating-profit growth of at least 14% in the six months ended June. The consensus projects per-share-profit growth of 19% in the second half of second half of 2013 and 20% in 2014. Alliance is a Focus List Buy and a Long-Term Buy.


EMC's ($26; EMC) Quadrix Overall score has risen to 95 from 76 at the end of April, lifted by improved operating momentum, positive earnings-estimates trends, and stock-price gains. Unlike most tech stocks, EMC trades at a discount to historical norms. At 15 times trailing earnings, EMC is 35% below its three-year average P/E, while the price/operating cash flow ratio of 8.9 is 14% below the historical average.

A survey by 451 Research suggests data-storage budgets should rise over the next 12 months, albeit at a slower rate than in 2012 or 2011. More than one-third of the survey respondents expect to increase spending on EMC products this year, possibly because of a series of product upgrades. EMC is a Long-Term Buy.


Visa's ($174; V) shares had risen in 10 of the 11 months before July, when a U.S. District Court judge invalidated a Federal Reserve regulation capping the fee for debit-card transactions at $0.21. Before settling on $0.21 in October 2011, the Fed had considered lowering the cap to $0.12. Retailers had hoped the Fed would rework the legislation with a lower cap in the wake of the judge's actions, but the central bank announced in August that it would appeal. The appeal will test the extent of courts' power to countermand financial regulations.

The judge suspended his judgment, effectively reinstating the cap, though he also told the Fed to write an interim rule pending the appeal. The Fed opposes an interim rule.

In each of the last six fiscal years, Visa delivered at least 10% sales growth and 21% profit growth. Visa is a Buy and a Long-Term Buy.

TECH SECTOR BREAKDOWN: AVERAGES BY SIZE, INDUSTRY
Quadrix scores are percentile ranks, with 100 the best. The reranked Overall and 12-Factor Sector scores compare stocks to others in the same sector.
--- Price/Earnings ---
Per-Share-
---- Profit Growth ----
------------------ Quadrix Scores ------------------
Group (No. Of Companis)
Trailing
Vs. 5-
Yr. Avg.
12
Months
(%)
3 Yrs.
(Annual.)
(%)
Value
Overall
12-
Factor
Sector
Reranked
Overall
Technology Sector (266)
21
0.96
1
10
51
54
50
50
   Semiconductors & Equipment (61)
22
0.85
(9)
(2)
41
39
34
32
      Semiconductor Equipment (20)
21
0.76
(15)
2
40
28
19
23
      Semiconductors (41)
22
0.86
(7)
(4)
41
44
41
36
   Software & Services (113)
22
0.98
7
15
50
61
57
58
      Internet Software & Services (26)
26
0.88
6
32
45
60
61
56
      IT Services (41)
19
1.09
10
12
62
70
55
68
         Data Processing (28)
18
1.12
13
13
61
73
55
71
         IT Consulting & Other Svcs. (13)
21
1.05
5
10
64
63
55
61
      Software (46)
23
0.87
4
10
42
54
57
51
         Application Software (32)
23
0.85
0
11
39
51
57
47
         Home Entertain. Software (2)
30
NA
42
(21)
24
48
43
51
         Systems Software (12)
22
0.93
8
11
56
65
61
61
   Tech Hardware & Equip. (92)
19
0.99
(1)
8
58
56
51
51
      Communications Equipment (27)
20
0.88
2
0
56
52
51
46
      Computers & Peripherals (19)
16
0.91
(4)
10
64
63
55
59
         Computer Hardware (8)
21
0.95
(9)
17
58
49
46
45
         Computer Storage (11)
13
0.88
1
5
68
74
61
69
      Electronic Equip. & Instrum. (44)
20
1.08
(2)
11
56
54
50
50
         Electronic Components (7)
18
1.20
(7)
3
53
57
48
53
         Elect. Equip. & Instrum. (15)
26
1.02
(1)
16
46
43
45
39
         Electronic Mfg. Services (13)
19
1.02
6
11
55
54
50
50
         Technology Distributors (9)
12
1.12
(6)
8
77
70
59
69
      Office Electronics (2)
14
0.94
6
16
77
67
49
62
Stock-Mkt. Value > $10 Billion (44)
17
0.96
2
10
59
67
50
63
Stock-Mkt. Value $3 Bil. To $10 Bil. (57)
22
0.90
6
14
53
64
58
61
Stock-Mkt. Value $1 Bil. To $3 Bil. (81)
22
1.00
(5)
7
48
53
52
49
Stock-Mkt. Value Up To $1 Billion (84)
22
0.97
3
9
47
41
42
35
Note: Averages exclude some outliers.     NA Not available.

 

FORECASTS RECOMMENDED TECHNOLOGY STOCKS
Price/Earnings
Price/Sales
12-Month
--- Growth ---
----------- Quadrix Scores -----------
Company (Price; Ticker)
Stock-
Market
Value
($Bil.)
Trailing
Vs. 5-
Yr. Avg.
Trailing
Vs. 5-
Yr. Avg.
Sales
(%)
Profits
(%)
Value
Overall
12-
Factor
Sector
Reranked
Overall
Industry
Alliance Data Sys.
($196; ADS)
13.4
21
1.16
2.4
1.42
15
9
44
72
80
81
Data
Processing
Apple ($489; AAPL)
451.6
12
0.72
2.6
0.73
14
(6)
93
93
92
93
Hardware
Cisco Systems
($23; CSCO)
127.7
12
0.76
2.6
0.94
6
14
88
93
62
94
Telecom
Equip.
Cognizant Tech.
($72; CTSH)
22.0
18
0.81
2.7
0.77
18
20
70
93
90
93
IT Consulting
EMC ($26; EMC)
55.9
15
0.69
2.4
0.98
6
5
86
95
94
94
Storage
Google
($850; GOOG)
287.6
21
0.91
5.1
0.87
31
0
49
60
39
58
Internet
Software
Qualcomm
($66; QCOM)
116.5
15
0.69
4.9
0.78
27
32
74
97
92
99
Telecom
Equip.
Visa ($174; V)
113.4
24
1.10
9.7
1.24
15
50
24
84
73
83
Data
Processing
Note: Quadrix scores are percentile ranks, with 100 the best.

 

 


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