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Information Technology Sector Rating: Marketperform

By

Brad Sorensen

photo
CFA, Managing Director of Market & Sector Analysis, Schwab Center for Financial Research

Brad Sorensen heads market and sector analysis for the Schwab Center for Financial Research and writes for several Schwab publications. He is a member of Schwab's Investment Strategy Council.

Before joining Schwab in 2004, he was a senior analyst at AMG Guaranty Trust, where he designed portfolio strategies for high-net-worth individuals. Sorensen graduated from the University of Colorado with a bachelor's degree in finance and master's degrees in business administration and finance. He is a Chartered Financial Analyst charterholder.

October 11, 2018

Member for

1 year 8 months
Submitted by satya.billa on Thu, 10/11/2018 - 14:01
Information Technology Sector

Information technology sector overview

After a long-held outperform rating, we recently moved to a neutral rating. Corporate spending could be delayed by tariff concerns, which could affect the profitability of the group.

Market outlook for the information technology sector

The tech sector has undergone some fairly large changes, as some of its largest companies have moved to the communications sector. As we’ve written before, we believe (and the data seems to show) that the resulting technology sector is a bit more defensive in nature, with higher dividend yields and lower price-to-earnings ratios (according to Cornerstone Macro Research). For now we are not changing our recommended rating on the sector, but given the new characteristics we are going to be carefully watching how the sector behaves over the next couple of months.

We still like technology, but are a little more concerned in the near term about some negative factors facing the sector, and recently reduced our rating to marketperform as a result. As our Chief Investment Strategist Liz Ann Sonders often says, “better or worse matters more than good or bad” and after an earnings beat rate of 89% in the second quarter (according to Thomson Reuters), it’s difficult for us to imagine things getting substantially better as we head into Q3 earnings season. Additionally, we still believe in the need for companies to expand their spending on capital improvements, especially in the technology area, but are concerned that trade concerns may delay some of that spending.

However, the U.S. consumer now seems to us to be willing to spend more on technology and consumer confidence remains near its highest level since 2000, according to the Conference Board, showing little impact from tariff concerns. This should help support the tech sector and leaves us still positive on the group, just not quite as much.

Although we’ve been waiting for a move higher in capital spending for some time, we are encouraged by the September National Federation of Independent Business survey that showed capital spending plans remained high, but did weaken slightly and we remain concerned those plans may fall further should the trade disputes drag on and escalate.

Balance sheets in the information technology sector appear solid, with large cash balances and relatively low debt. In our opinion, this enables the group to pursue mergers and acquisitions that might help performance by removing competition and consolidating expenses but those may be delayed by uncertainty surrounding trade. Additionally, we have seen tech sector companies increase their dividend payments, which may become a larger part of total equity return in the near term, while they have also increased share buybacks, which helps to reduce available shares to be purchased.

So we aren’t negative on the group despite the downgrade, but we do think, for now, that the risks are more balanced with the return potential and believe that a more neutral rating is appropriate for the time being.

Factors that may affect the information technology sector

Positive factors for the technology sector include:

  • Increased technology spending: With productivity relatively weak, companies should look to technology upgrades to improve efficiency. Capital expenditures have been below trend for several years, and a return to more normal spending levels would boost the sector.
  • Wage increases: Increasing wages, including raising the minimum wage in various areas, could push companies to turn to technology to replace increasingly expensive human workers.

Negative factors for the technology sector include:

  • Increasing global competition: Competition, especially from areas with low labor costs, will likely continue to compress profit margins.
  • Increased regulation: There is an increased risk in our view of some potentially damaging regulation, which could impact revenues and increase costs of certain areas of the tech sector.
  • Trade disputes: If trade conflicts escalate it could raise costs for American producers and prices for consumers.
  • Capital spending delays: We continue to see signs that companies remain hesitant to increase capital investment beyond what is absolutely necessary, although there are signs that is beginning to end.

 

Clients can see our top-rated stocks in the information technology sector.

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