Article / 23 February 2012 at 15:04 GMT

Tech stocks - the next bull rally?

Equity Analyst

The technology sector has been the big loser in terms of valuation contraction for the past decade but it seems that the dead trade of the decade has potentially woken up again. Like the many slumbering tech giants of the past decade, Microsoft and others were blessed (or cursed) with fantastic valuations during the 2000 Tech bubble. These valuations were so high that many of these companies are still trying to catch up to those stock prices.
 Tech Valuation

So what happened in the past 12 years? Unsurprisingly, of all the sectors, the Information Technology sector of the S&P500 had the second highest earnings growth of all the sectors, second only to energy. And in the past 6 years? IT was the best! It even beat the ever steady healthcare and consumer staples sectors.Sector EPS growth

While investors assumed that technology companies had not accomplished much after the tech bubble, tech companies did the complete opposite and provided lots of cash and earnings for their investors. Microsoft, IBM, Oracle, Cisco and Intel all had impressive growth (see chart 2). Too poor earnings, like everything else in life though, has a price. And there's cause for some rethinking if you were willing to pay 70-80x earnings for a whole sector. Big Tech EPS growh

Although these companies did not grow by 30 percent every year for 10 years (not many companies have), the tech sector was still one of the strongest sectors of the decade.

Bottom line: tech is cheap!
So how can we explain that the tech sector is trading at a very attractive, almost too attractive level?  We can take the academic route and try to argue that the tech sector is riskier than most and that investors are simply heavily discounting the returns because of the related uncertainty. As we have shown in this previous chart, historical earnings have been strong and steady for the IT sector, which should have decreased investors’ fears. Just as an example, FY1 P/Es for Oracle, IBM, Intel, Microsoft and Cisco are 13, 13, 10, 11.5 and 11.5 respectively.

If we take the valuations of more defensive, no growth sectors like telecommunication and utilities, we see that these two sectors’ earnings are actually less expensive than the steady, high growth tech sector, so something doesn’t seem quite right. IT Telcos utils

So what gives??? I cannot seem to get my head around why the technology sector is trading so cheaply and I also do not care to understand it, as Mr. Market is often very wrong. But he does tend to correct himself, often quite rapidly.

Is tech risky? Valuations are very low so a multiple contraction seems unlikely. Earnings risk is possible, so can we expect technology to grow? The increasing need and use of data in our daily lives, the cheapness of data, and the interconnectivity of the different facets of our lives, and the move from a physical world to a digital world is as strong as ever. Given the sector’s steady historical growth and its prospects, earnings risk appears limited. Low expectations and a high growing sector is the perfect recipe for a new tech run. Will you get on it?


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