The technology sector has significantly outperformed the MSCI World Index year-to-date (YTD) through April, rising 14% versus 6% for the full index (Exhibit 1 below shows the performance of the different technology sub-sectors relative to the MSCI World Index). The strength has been led by the internet and software industries, as well as by the technology hardware industry group, driven by Apple. The semiconductor and semiconductor equipment industry has been a relative laggard, but has still outperformed the global market.
Exhibit 1: The MSCI Information Technology index (dotted green line) has outperformed the MSCI World index (dotted blue line) YTD
Source: FactSet, as of 17/05/17
There have been three primary, interrelated reasons for the outperformance of the US technology sector YTD. First, investors are increasingly attracted to the compelling secular growth themes, including artificial intelligence, automation and cloud computing. Second, the rotation out of the technology sector in 2016 after the US election – to fund investments in more cyclical sectors including financials and industrials – has abated. And third, Apple shares have rallied in anticipation of the significant innovation in the upcoming iPhone product launch. Apple accounts for 2.3% of the MSCI World Index, over 14% of the tech component and almost 52% of the technology hardware industry group.
Secular themes are driving performance in the technology sector, and we focus on identifying those companies that are leading and adopting innovation. While most of the themes have been developing for years, there is evidence that the adoption of cloud computing and breakthroughs in artificial intelligence are accelerating. Investors are becoming increasingly aware of this acceleration and looking for exposure to these themes. While the themes look set to last, investor interest may ebb and flow over time, creating uneven investment performance albeit most likely with a distinctly positive long-run trend.
With respect to sector rotation, there was a sharp post-election move led primarily by hedge funds out of the technology sector, which had performed well, as investors sought more exposure to interest rate-sensitive financials stocks and to those expected to benefit from rises in infrastructure and defence spending (see Exhibit 2 below). US-domiciled technology stocks comprise over 85% of the MSCI World IT sleeve, so the outflows had a material impact on global results. More recently, technology has returned to the leadership quadrant relative to the other sectors. Looking ahead, the sector rotation trajectory is uncertain, but it could reverse and create a headwind for some time.
Exhibit 2: Technology (green line) dropped from leading to weakening and then reversed suddenly. Period between October 2016 and April 2017
Source: Bloomberg, as of 17/05/17
Apple may continue to outperform as its set-up is positive for the new product launch in September. The installed base of close to 650 million iPhones is approximately 75% larger than prior to the iPhone 6 launch three years ago, which was the last time the company made a significant form factor change. This metric alone would suggest the sale of approximately 215 million units in the first full year (FY 2018e ending in September 2018), assuming a three-year replacement cycle. The organic light-emitting diode (OLED) screen, wireless charging and other enhancements in the iPhone 8 should also attract significant numbers of switchers from the Android platform, as did the iPhone 6 Plus, so there is potential upside to consensus expectations of 241 million units. Earnings estimates should continue to drift up ahead of the launch, as more analysts incorporate average selling price (ASP) increases which would complement the strong unit growth. The ASP increases are driven by the expected popularity of the iPhone 8 relative to new iPhone 7s and 7s Plus models, with the iPhone 8 potentially selling at USD 100 – USD 130 more to cover the extra cost of the new hardware features. We are also positive on the service revenue opportunity for Apple, as the company increasingly monetises the installed base.
Exhibit 3: Apple drove the outperformance of the hardware industry group, of which it comprises around 52%
Source: FactSet, as of 17/05/17
Looking forward, bottom-up fundamentals suggest that the outperformance of the technology sector should continue. In the near term, earnings and guidance show generally strong execution by companies, and point to a continuation of many of the secular growth themes that we track. Most companies produced “beat and raise” quarters in Q1 2017, and many of those that did not do so cited higher investment to capture future growth.
One notable exception to the strong growth trends is wireless infrastructure spending in China, but there is evidence that this slowdown is a temporary pause as the focus shifts from the national backbone managed by the central government to metro network buildouts, which are driven provincially; the 2020 goals for wireless investment in China remain intact. Some investors anticipate a semiconductor industry downturn, which has held this part of the sector back year-to-date, but we think any cyclical considerations are outweighed by significant and continuing content gains in mobile, automotive, and industrial applications, and we remain bullish on semiconductor stocks going forward.
While there is always uncertainty as to the pace of innovation and technology adoption, the fundamental set-up is positive, in our view. On the downside, investor expectations have risen along with valuations, although in general, valuations remain in line with the market. A geopolitical or macroeconomic shock would interrupt, but likely not derail, the sector’s winning streak. As an interesting observation, the S&P500 tech sector, at 956.88 on 15 May 2017, is within striking distance of the all-time high of 988.49, set in March 2000 (see Exhibit 5 below). However, we are not concerned about a bubble. Back then, the relative P/E ratio of the technology sector was 2.14x; today it is 1.06x (see Exhibit 4 below).
Exhibit 4: S&P IT PE and EV/EBITDA multiples relative to S&P500 Index [note – 20 year average is 1.26x for relative PE]
Exhibit 5: The valuation of the IT sector within the S&P 500 index is less than 5% below the March 2000 peak, but it took 17 years to get here
Source: FactSet, as of 17/05/17
Written on 17 May 2017