US tech stocks are an enticing proposition

IN AN eye-catching achievement for a company that has never made a profit, Twitter’s share stampede last week sent the value of the social networking platform to $24bn (£15.12bn) on its stock market debut, although its shares have since dropped back to around $42. Many investors, however, are still understandably cautious about investing in high-profile social media brands, following the disappointing Facebook float last year. We believe, however, that the US technology sector is an attractive proposition.
ROOM TO GROW
What makes technology a good bet? The answer is that the sector offers an appealing balance between risk and reward. Twitter notwithstanding, US tech is trading at an unjustified discount to the broader market, despite its solid growth prospects. In our view, earnings growth in technology will outpace the market over the next few years, based on several important long-term growth drivers. These include the growth of cloud computing, online advertising, mobility and e-commerce, but also the sector’s exposure to fast-growing emerging markets, and pent-up enterprise demand. And as the major economies move through the recovery phase, accelerating global profit growth should unleash corporate capital spending on IT infrastructure.

Additionally, despite strong dividend growth of 20 per cent (annualised over the past seven years), we see further robust growth ahead. This will result in yields becoming more competitive than the broader market over time. Accounting for share buybacks as well as dividends, the US technology sector now offers a higher yield than the S&P 500.

DOUBTS REMAIN
Sceptics will rightly point out that the sector has recently been struggling. Certainly, on a market cap weighted basis, tech has lagged in 2013 – a victim of a mixed business spending environment, as well as a broader sector rotation into market segments with above-average domestic US cyclical exposure. But with non-US economies looking increasingly healthy, global enterprise spending will begin to pick up, and investors will focus on sectors that are cheap and have global cyclical exposure.

Admittedly, the US tech earnings season has been uneven. The sector posted the largest percentage gain in earnings among the ten major industry sectors, but forward-looking guidance was mixed. So far, there is no conclusive proof of a positive inflection point in growth. The good news, however, is that this uncertain outlook is more than reflected in the sector’s current low valuation, suggesting that the balance of risk and reward is favourable.

GOOD TIME TO BUY
Current valuations are a strong indication that now is a good time to buy. The US tech sector trades at a valuation discount of nearly 4 per cent to the US market, compared to its average premium of 32 per cent over the last 18 years. Historically, investors have been well-served by buying tech shares when the sector trades at under 15-times earnings. While past returns should not be seen as a guide to future performance, it is important to note that, since 1989, the median 12-month forward return under such conditions has been 20 per cent.

Perhaps more significantly, downside risk has been relatively limited when sector price against earnings are this low. In addition, tech’s free cashflow yield of 7 per cent is the second highest of any sector in the US market.

While some US IT companies are playing catch-up in adjusting to our fast-paced mobile world, aggregate sector earnings growth should still outpace the equity market as a whole, as winners gain at the expense of losers. We see further robust growth ahead, leading yields to become more competitive against the broader market over time.

Bill O’Neill is head of CIO research UK at UBS Wealth Management.