Ask CIO: Is US Technology still attractive?

4Q18’s correction was due to the market adjusting, in response to the cautious earnings guidance by selected companies.
Chief Investment Office30 Jan 2019
Photo credit: AFP Photo

In recent conversations with our clients, we received many interesting questions, and will be addressing them in a new series of CIO Perspectives, “Ask CIO”. We hope you find this insightful and enjoyable.The MSCI US Technology index experienced a massive correction in 4Q 2018, whereby the index corrected some 24% from peak on early October before rebounding 13% from the Christmas Eve trough. All in, between the peak and now, the US Technology sector has corrected 14%.

The MSCI US Technology Index experienced a massive correction in 4Q18, by some 24% from its peak in early-October, before rebounding 13% from its trough on Christmas Eve. All in, between its peak and now, the US Technology sector has corrected 14%.

A key trigger was the unexpected downward earnings guidance from a few bellwether technology giants, namely Inc and Apple Inc; investors reacted to the more realistic earnings expectations.

Based on our analysis, the forward earnings-per-share (EPS) projection has stayed resilient and the divergence between technology stocks and EPS trend is not warranted (Figure 1). Within the broader Technology sector, the downward guidance among some companies was offset by better earnings outlook in others.

We view the recent correction in the US Technology sector as an opportunity to re-engage. This aligns with our barbell strategy, advocated in our CIO Insights 1Q19, to maximise risk-return. We view the recent correction in the US Technology sector as a window of opportunity for portfolios to re-engage. This aligns with our barbell strategy, advocated in our CIO Insights 1Q19, to maximise risk-return in this time of market volatility.

Why US Technology remains in a sweet spot:

1.        Over the years, US technology companies have developed a strong portfolio of patents and intellectual property, giving them ultimate control over product design, hardware specifications, development of application processors, operating systems, as well as semiconductor chipsets.

2.        US technology companies keep a tight grip on their supply chain. They outsource most parts of the assembly, component manufacturing, labour works, and inventory burden to Asia; the region generally has lower profitability due to higher capital requirements and labour intensity. This has resulted in superior earnings for US technology firms, as seen in the doubling of actual free cash flow per share since 2010 and consistent expansion in operating margins (Figure 2).

3.        US technology firms have amassed large amounts of cash and some of them are standing tall on net cash in their balance sheets, giving them the financial muscle to execute mergers and acquisitions (M&A) that would be accretive to earnings and enhance their competitive advantage.

Figure 1: The US Tech sector corrected near the end of 2018

Source: Bloomberg, DBS

4.        The essential elements are still principally in the hands of these US companies. End-user databases, application portfolios, payment backhauls, and direct access to end customers are still firmly controlled by the industry’s leaders. Notably, strong brand recognition further cements their global positioning and product pricing power.

Figure 2: Strong operating profit margins and free cash flow

Source: Bloomberg, DBS

Light at the end of the tunnel: some companies still have positive earnings guidance. While some big names like Amazon, Apple, and Nvidia Inc might have guided cautious earnings outlook in the near term, citing the impact of trade tensions and slower end demand, there are still companies confident in their earnings outlook. These include firms concentrating on the payment space, server storage, data base management, and networking systems.

With the decade-long earnings expansion, the future promises higher-quality growth and sustainable earnings. For example, US e-Commerce and IT firms are enlarging their portion of recurring revenue which could deliver higher-than-corporate profit margins on the back of scalability and sustainability (Figure 3).

Figure 3: Consistent and stable earnings outlook

Source: Bloomberg, DBS

Earnings continue to stay constructive. 68% of firms in the S&P 500 Information Technology Index announced earnings, out of which 85% had positive surprises, as of 30 January 2019 (Figure 4). Apple’s highly-anticipated results came in within expectations, offering the market some relief. The results were partly helped by its non-smartphone businesses – the rise in services revenue enabled the company to grow its recurring business. Meanwhile, Advanced Micro Devices Inc, the world’s second-largest producer of computer processors, had in-line earnings and an inspiring revenue guidance for 2019, as opposed to rival Intel. These data should provide the market with the much-needed confidence support that the worse is likely to be over.

Figure 4: Constructive earnings surprises among tech stocks

Source: Bloomberg, DBS

Shareholder returns remain sustainable. After the short blip in early 2018, the actual return on equity (ROE) among US Technology firms has returned to an uptrend and reached a new high of 27%, demonstrating compelling shareholder returns. This is likely to be supported by a similar uptrend in the return on capital (ROC), as firms continue to commit capital outlay to develop new technologies. The consistent uptrend of both ROE and ROC is a favourable factor in substantiating the premium price-to-book (P/B) valuations.

Figure 5: High ROEs reinforced by strong ROCs

Source: Bloomberg, DBS

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