Like other cyclical sectors, the technology sector has recently been stung by the flareup in trade tensions between the U.S. and China. While that is an obvious headwind for exchange traded funds, such as the iShares U.S. Technology ETF (NYSEArca: IYW), some market observers are recommending investors stick with tech this summer.
While the sector is facing some near-term headwinds, technology remains home to some of the most prodigious free cash flow generators in the U.S. and that is a factor for long-term investors to remember.
“Given the vast and indomitable value that is at stake over the future of technology, how it evolves, and to whom that value will accrue, it should not be surprising that this would become the next site of political and economic conflict,” said BlackRock in a recent note. “Indeed, the cash flow generation potential of these capabilities is seemingly limitless considering their asset-light business models, nearly immediate global penetration, and the invaluable services they provide to global consumers.”
IYW reflects the performance of the Dow Jones U.S. Information Technology Index, which includes all tech sector picks in the Dow Jones U.S. Index. Due to the Dow Jones’ classification of information tech names, healthcare technology stocks may be included while payment technology stocks are excluded.
Benefits Of Tech ETFs
When considering a sector pick, investors should still do their due diligence. For example, one should survey macro economic environment and analyze business cycles, position according to changes in certain macroeconomic variables, identify secular industry trends, harness long-term growth rends within a particular segment, evaluate sector fundamentals, position towards areas that show attractive valuations and overweight or underweight sectors based on recent performance.
“Clearly, the “winners” going forward will be entities that have an ability to enhance their return-on-equity (ROE) with persistent growth in revenues and margins,” according to BlackRock. “Pricing power is the critical component of this equation. Just as ubiquitous information has squeezed the alpha out of financial market “fast followers,” so too has information transparency eroded the producer surplus of old-world businesses.”
Several of IYW’s top 10 holdings, including Microsoft (NASDAQ: MSFT), Apple Inc. (NASDAQ: AAPL) and others, have strong balance sheets and robust ROE.
“Devoid of pricing power, some goods-based companies have turned to increased leverage to boost ROE, but while leverage can help optimize one’s capital structure, leverage can also be a potential threat, if EBITDA growth and cash flow generation are not there to support increased debt levels,” notes BlackRock. “Therefore, we’re in search of entities that can strike the appropriate balance between durable pricing power and margins, and optimally levered cash flows.”
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