In my previous blog posts, I explained why I believe the U.S. tech industry, particularly blue-chip, mature companies, has room to run in this expensive bull market.
We’ve talked about the hefty balance sheets held by some of the best-known, established brands, which can help them deliver returns to shareholders. And we’ve discussed how their strong quarterly earnings support their higher valuations.
Another reason we like mature U.S. tech is that it’s a cyclical industry. In other words, when the economy gets stronger, cyclical sectors like tech have tended to generate higher revenues through increased consumer spending. Companies with higher revenues have a greater opportunity to increase shareholder-friendly policies compared to industries that are “defensive” in nature.
Due to continued resilience in U.S. economic growth and anticipation that the Federal Reserve will likely raise interest rates this year, we’re starting to see investor sentiment transitioning from defensive to cyclical stocks. Here’s why:
The defensive end
Typically, defensive industries―such as utilities and consumer staples―do well during a recession because people and companies restrict their spending to necessities. Since their revenue is relatively stable, many companies can afford to pay consistent dividends. Investors, therefore, gravitate toward them for stable income and lower potential volatility.
But some defensive sectors, like utilities and telecom, are also capital intensive and carry enormous levels of debt. When interest rates rise due to a healthier economy, these defensive companies come under more pressure because of increased borrowing costs. This can erode profitability and eventually depress their stock prices.
What’s more, with valuations in these sectors at historically high levels, this leaves much of the defensive universe, particularly in the United States, vulnerable. For example, U.S. utility companies are currently trading at approximately 19 times trailing earnings, a 7% premium to the broader market. Over the past 20 years, U.S. utilities have traditionally traded at a discount, roughly 20% on average. The high relative valuation is supported, for now, by low yields. However, should real rates rise even modestly, it would be much harder to sustain current values, suggesting the sector would be likely to see its multiples (price-to-earnings ratio) contract relative to the broader market.
Cycling forward
As the economy grows, consumers tend to spend more on discretionary items and companies feel confident to invest in their expansion.
The U.S. tech sector is particularly poised to take advantage of this cyclical economic shift. As my colleague, Russ Koesterich, and I discuss in our new white paper, “U.S. Tech: Sending a Strong Signal,” health care, finance and other service industries are likely to increase investment in information technology―everything from data storage to new desktop computers. Also, the large millennial population will drive the usage of mobile technology and online networks.
And historically, tech has weathered interest rate hikes better than many other sectors. Today, the overall tech sector holds more than half of total corporate cash reserves in the U.S., which means if rates rise, mature U.S tech will better positioned to handle increasing borrowing costs and invest in their own growth.
Not too late
We still see solid upside potential in U.S. tech stocks, and the iShares U.S. Technology ETF (IYW) is a simple way to increase your investment in the sector. It provides dedicated exposure to electronics, computer software and hardware, and information technology stocks. And its top holdings include mature tech companies such as Apple, Microsoft and Intel[1].
When’s the best time to buy? We anticipate increasing volatility in the stock markets this year, and tech is no exception. So keep an eye on market pullbacks and consider investing on the dips.
Source: Bloomberg as of 1/15/15
Heidi Richardson is a Global Investment Strategist at BlackRock, working with Chief Investment Strategist Russ Koesterich. She also leads the iThinking initiative for iShares. You can find more of her posts here.