3 Reasons to Give Tech Funds the Ol’ Heave-Ho

by Daniel Putnam | November 12, 2013 11:02 am

The days of massive outperformance for tech stocks might be in the rear-view mirror, but that hasn’t stopped investors from remaining infatuated with the sector. More than $25 billion is invested in technology exchange-traded funds, with nearly half of that in the Technology SPDR (XLK[1]).

Unfortunately, the tech sector isn’t delivering the goods. Not in growth. Not in valuation. Heck, not even in beta.

This is a critical consideration, since a sector ETF needs to offer a measure of added value over an index fund that provides exposure to the broader market, such as the SPDR S&P 500 ETF (SPY[2]), for the investment to make sense. But capitalization-weighted funds such as XLK are missing the mark on all counts.

Growth

The first metric where tech falls short is earnings growth: Factset[3] estimates that tech stocks are on track for 1.7% EPS growth in 2013, vs. 4.9% for the S&P 500. For 2014, it’s the same story. Tech is expected to grow at a 9.6% pace, short of the 10.8% of the broader market.

There are three likely reasons for this. First, tech spending as a percentage of corporate capital spending as flattened out near the 50% line in recent years, indicating that tech — as a whole — has exited the rapid-growth phase and become a more mature industry. Second, smartphones have become increasingly commoditized, pressuring results throughout the supply chain — as evidenced by Qualcomm’s (QCOM[4]) miss earlier this month. Finally, there currently just isn’t the type of game-changing, iPhone-like product that can create an ecosystem and provide a lift to the entire sector.

This lack of market-beating growth potential is visible in the type of large, mature and slow-growing companies that make up the bulk of the holdings in funds like XLK, including International Business Machines (IBM[5]), Microsoft (MSFT[6]), Cisco Systems (CSCO[7]) and Hewlett-Packard (HPQ[8]).

Value

The lack of growth would be manageable if the tech sector were trading at a deep discount to the rest of the market, but that isn’t the case. Tech stocks are trading at 14.3 times 12-month forward estimates, in line with the 14.7x of the broader market. This is certainly more attractive than the averages of the trailing five-year (13.6x for technology versus 13.0x for the S&P) and 10-year (16.8x versus 14.0x) periods, which indicate that the extended period of underperformance for the sector might have played itself out.

It also makes technology more attractive to sectors that are trading at above-average historical premiums, such as consumer staples. But at the same time, an in-line valuation doesn’t make tech a screaming buy relative to a broader-based index funds.

Beta

The tech sector used to be the place investors could go to achieve index-beating returns in rising markets, but not anymore. According to Yahoo! Finance, XLK has a beta of just 0.77 relative to the S&P 500 in the past three years. Lower risk is an attractive quality, of course, but not necessarily what investors are looking for when they decided to allocate assets to a tech fund.

This is reflected in XLK’s total return, which is behind that of the S&P 500 over all time periods throughout the current bull market:

Year-to-date 1-Year 3-Year Since 3/9/09 Low 5-Year
SPY 26.3% 31.3% 15.5% 25.4% 16.0%
XLK 19.2% 23.0% 12.4% 24.3% 18.2%
Average annual returns through Nov. 8

The Bottom Line

Investors tend to have long memories, and it’s likely that many are still looking at the technology sector as the same source of dynamic growth and innovation that characterized the group in the 1990s. And for many individual companies — particularly in the sector’s small- and midcap segments — that’s still true.

For those looking for a sector play, however, the tech sector — and funds such as XLK — have little to offer relative to the broader market.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

Endnotes:
  1. XLK: http://studio-5.financialcontent.com/investplace/quote?Symbol=XLK
  2. SPY: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPY
  3. Factset: http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&cad=rja&sqi=2&ved=0CCoQFjAA&url=http%3A%2F%2Fwww.factset.com%2Fearningsinsight&ei=oo6BUpnuB5OLkAfx14HADQ&usg=AFQjCNEnVVhS6kROKnH3Uaqc_1ZhjvZX3Q&bvm=bv.56146854,d.cWc
  4. QCOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=QCOM
  5. IBM: http://studio-5.financialcontent.com/investplace/quote?Symbol=IBM
  6. MSFT: http://studio-5.financialcontent.com/investplace/quote?Symbol=MSFT
  7. CSCO: http://studio-5.financialcontent.com/investplace/quote?Symbol=CSCO
  8. HPQ: http://studio-5.financialcontent.com/investplace/quote?Symbol=HPQ

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