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Is The Tecnology Sector Still Attractive?
Malaysia Perspective | 27 July 2011

By The iFast Research Team

Global investors’ appetite for risk was significantly dampened over the last two months as the market was flooded with negativity arising from slowing global growth as well as re-ignited European debt woes. As a result, risky asset prices corrected, giving up gains made year-to-date, with some even in the red.

At the end of 2010, we highlighted our conviction in the global technology sector (refer to article“Key Investment Ideas for 2011”, point 5 – Resurgence of optimism about technology, 10 years on). However, on a year-to-date basis, the global technology (represented by MSCI AC World IT Index) was the second worst performing sector, down 5.0% versus a 0.5% decline in the MSCI AC World index. Best performing was Health Care sector followed by the Consumer Staples sector, which gained 9.4% and 5.0% respectively (see chart 1).

Technology Sector Was Hot By Risk Aversion
While on a year-to-date basis the technology sector’s return is disappointing, the sector has actually started the year with a strong outperformance over the MSCI AC World index. However, with the onslaught of the geopolitical instability in Middle East, technology stocks retreated as investor confidence dived. Nevertheless, the sector performed on par with the general market until Japan’s triple disaster hit. With Japan being an important technology hub, supply disruption affected near-term profitability of the global technology sector. The technology sector’s underperformance narrowed soon after, only to be stopped by a rise in global risk aversion ignited by renewed European debt woes (see chart 2).

Is The Tech Rally Over?
As the Technology sector surrendered earlier gains due to rising risk aversion, it is inevitable that investors start wondering if the rally still has room to run. Looking at the underlying fundamentals as well as some valuation metrics, we continue to find some compelling reasons to remain bullish on the sector. We list the reasons below.

#1: Valuation Premium Versus MSCI AC World At All-Time Low
On a historical basis, the technology sector has traded at a premium over global equities in general. Given the higher growth opportunities as well as being the forerunner of innovation, the market is willing to commit a premium for owning technology companies, once even to excessive levels that did not appear sustainable, which eventually led to the technology bubble bursting in early 2000s (see chart 3).

However, excluding the recent financial crisis period, the technology sector is currently trading at a record low premium of just 5% above the MSCI AC World. At current level, the market has discounted the sector’s higher rate of growth, which we do not believe is justified. The valuation premium is likely to normalise once risk appetite return to the market and investors are once again willing to pay for rapid growth.

#2: Technology Sector Has One Of The Best Profitability And/Or Growth Profile
With reference to chart 4 (data from Bloomberg, as of 20 June 2011), among the 10 GICS Sectors, the technology sector has one of the highest profit margins of 18.3%, second only to the financial sector. This highlights the ability of technology companies to convert sales to earnings. However, the technology sector has also the lowest dividend yield of 1.4% compared to a 2.6% dividend yield for the MSCI AC World index. Earnings not paid out in dividends will be used for future growth, which is a function of retained earnings and return on equity (ROE).

Incidentally, the technology sector has the second highest ROE of 28.5% compared to a 20.8% for the MSCI AC World index. This reaffirms the high growth nature of technology companies and hence the valuation premium it used to trade at versus the MSCI AC World index. Lastly, the technology sector has one of the highest cashflow-to-sales (CF/Sales) ratio, a metric which measures the ability of a company to generate cash flow from sales, with a high value indicating sustainability.

#3: Rising Earnings Trend At Record Level
With strong earnings capabilities and an above average rate of growth, the technology sector has managed to recover swiftly from the recent financial crisis. Rebounding from a crisis low, the technology sector has managed to reach record earnings in 2010 and is projected to best itself consecutively over the next three years (see chart 5).

With the MSCI AC World IT index trading at 91.21 (in local currency as of 20 June 2011), the market trades at a forward PE ratio of 12.7X and 11.1X based on 2011 and 2012 estimated earnings. Assuming a reversion to a mean of 16.0X earnings, the market may have a potential upside of 44.0% by the end of 2012, a return which should appeal to investors.

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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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