Published on August 24th, 2020 📆 | 6153 Views ⚑0
Craving Technology: A Beginner’s Guide And Top 12 Picks
Software is Eating The World! – Marc Andreessen
You may have heard this or something similar in the past. And what this essentially implies is that technology is transforming how we experience the world or businesses operate. So as mere mortals, should we be trying to chase the hottest investment theme in the world or save ourselves by buying either the S&P 500 or any other safe ETF of choice? Today, my hope is to demystify the sector itself, show what drives its different sub-sectors, and how to invest in the sector with high conviction.
Before I get started, I want to let you know that this is my second article in the “Craving” series. In these write-ups, I hope to provide a high-level overview of a sector and discuss key sub-sectors and investment themes within it. My first article was on Healthcare – one of the top-performing sectors of the S&P 500 over the last decade – and it was very well received. So if you haven’t yet, you should definitely check it out.
I also want to clarify that I am looking at Technology from a five-year view and not looking to debate how the sector would trade in the short term, especially if there is a sharp reversal in investor sentiment.
Now, coming back to the topic of the day. The table below (last updated July 2020) neatly summarizes the performance of all the key sectors within S&P 500 over different periods. Technology (NYSEARCA:XLK) has outperformed every other sector and the S&P 500 (NYSEARCA:SPY) by a wide margin and over almost every period. The only other two sectors that have outperformed the S&P 500 are Healthcare (NYSEARCA:XLV) and Consumer Discretionary (NYSEARCA:XLY) – almost 24% of which is Amazon (NASDAQ:AMZN).
The outperformance has been so wide that if 10 years ago, you had invested $10,000 in XLK, it would have grown to ~$59,400, while the same in SPY would have resulted in ~$36,200. Almost $23,200 (~64%) more. So what does it mean for us?
Past performance is no indication of future returns. And there have been countless investors in the past who were allured by a new shiny object and burned themselves by running towards it.
I don’t think this is one of those situations. This outperformance hasn’t come by accident as there are secular tailwinds leading to this. Plus, I don’t see any structural changes in the recent future that would serve as a headwind for the sector. Having said this and even though I am a growth investor, I don’t just put my hard-earned money anywhere unless I am confident that the combination of current valuations and future growth justifies the price I’m paying for a business today. So let me start with sharing the three key reasons why I think the sector would be a winner in the long term:
- Secular Growth – Technology along with Healthcare is enjoying secular tailwinds that will continue to propel both revenue and earnings in the mid to long term. From my perspective, it all boils down to two words – effectiveness and efficiency. Every business on the entire planet is looking to better engage with their customers and it could be through marketing their product in new ways (e.g., Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG) (NASDAQ:GOOGL)), leveraging new shopping platforms (e.g., Amazon and Shopify (NYSE:SHOP)) or using new enterprise applications to better understand customers and build relationships (e.g., Salesforce (NYSE:CRM) and Adobe (NASDAQ:ADBE)). At the same time, every organization wants to operate more efficiently and hence investing in technology and automation whether through cloud infrastructure (e.g., Microsoft (NASDAQ:MSFT) and AWS) or SaaS platforms (e.g., Workday (NASDAQ:WDAY) and ServiceNow (NYSE:NOW)) or collaboration tools (e.g., Zoom (NASDAQ:ZM) and Slack (NYSE:WORK)). You get the point.
- Volatility – We have all learned that to get higher returns you need to take high risk. Considering Technology has left every other sector and the index itself in the dust, it should also exhibit higher volatility or drawdowns when the market goes south. You would be surprised to know that it’s not the case. Technology has outperformed the S&P 500 during good times and was able to hold relatively well during bad ones. The first table below shows that XLK experienced a maximum drawdown of only ~17.4% compared to ~19.4% for SPY, full 2% points lower. The second table below shows calendar year returns of different sectors, and even in 2018 – when SPY was negative – XLK outperformed SPY by ~2.9%. Don’t you love this?
- Valuation – You may have already led to believe that technology stocks have risen a lot, and there is no value left in them. I hold a different view. I agree they are expensive, but for a valid reason. And I have an imminent belief that if we are holding solid stocks with earnings visibility for the long term, earnings growth can cover the premium prices we may pay today. But let’s explore how expensive the sector is. The excellent charts below from Yardeni Research show that Technology forward PE is 25.8 compared to 22.0 for the S&P 500. A bit more expensive, but as soon as we look at the PEG ratio (PE / EPS growth), we are looking at a ratio of 2 for Technology compared to 2.1 for the S&P 500. Well, that’s not bad.
So by now, I am hoping that you are convinced that Technology is a must-own sector and are ready to place your order for XLK. Hold on. Let’s look under the hood and explore how to untangle the sector further.
So before I get into the details, let me share my investment beliefs. You can skip this section if you have read my prior articles.
- Conviction – I don’t invest in anything unless I am convinced about the story. This lets me stick with a stock whether it’s sunshine or rain, and it has served me well in the past.
- Growth – I believe a lot of people misunderstand growth. It’s as simple as the power of compounding. Considering my focus on total returns, I always value companies that show their ability to grow revenues profitably.
- Flexibility – I don’t think as a retail investor, we need to marry ourselves to a single investing style (e.g., high dividend, dividend growth). Even if you prefer dividend growth, it shouldn’t stop you from picking Google or Facebook, if you believe in their story.
My own portfolio is spread across ~40-45 securities, and I divide them into 3 buckets:
- Consistent Compounders – Proven business models, above-average growth rate (Medium Risk, Medium-High Return) – Think of GOOGL, UnitedHealth Group (NYSE:UNH), Honeywell (NYSE:HON).
- High-Flyers – Growing at a rapid pace, may have little to no profits (Medium-High Risk, High Return) – Think of AMZN, Netflix (NASDAQ:NFLX), Peloton (NASDAQ:PTON).
- Special Situations – Depressed valuations due to short- to mid-term challenges such as loss of confidence in management, significant debt, or industry overhangs (Medium-High Risk, Medium-High Return) – Teva (NYSE:TEVA), Simon Property Group (NYSE:SPG), AT&T (NYSE:T).
You can read more about my journey, investment beliefs, and allocations to these buckets here. Now it would become easier for me to take a deeper dive into the Technology sector and help you in developing a strategy that can outperform broad indices.
What makes up Technology?
I have been using XLK as the proxy for technology so far in this article, as it is the most widely used gauge, so makes it easier to pull the sector level research. But honestly, I prefer the iShares Expanded Tech Sector ETF (NYSEARCA:IGM) rather than XLK as some sector shake-ups in 2018 led to moving some of the core technology stocks such as Facebook and Google to Communications sector. Further, Amazon has been part of the Consumer Discretionary for a long time. So let me give you an overview of the differences between the two.
Source: XLK Holdings
Source: IGM Holdings
Let me highlight the three key differences between the two:
- As you may notice, only IGM provides you exposure to some of the core technology stocks such as Amazon, Facebook, and Google.
- I don’t know about you, but I don’t like ~45% of the portfolio being concentrated in just two names when I am investing in a relatively broad ETF.
- IGM has only 53% of its assets in the top 10 holdings compared to 70% for XLK, so your portfolio is a bit more diversified, plus you are buying ~300 stocks in IGM compared to only 71 holdings for XLK. So a bit more opportunity to expose to smaller tech names.
Overall, if you are an occasional investor and don’t have the bandwidth or interest to invest in 10 different stocks in one sector, do yourself a favor, and go ahead and buy IGM. If it’s the only tech name in your portfolio, make sure it has enough allocation (40-50%) and stop reading the article. For everyone else, who are as crazy as me, let’s dive deeper.
I will start with giving you a snapshot of the IGM sector breakdown from BlackRock.
I agree it’s a lot to digest. So to simplify this, I’d divide technology into four broad sub-sectors/industries:
- Consumer Technology / Internet (e.g., Amazon, Facebook)
- Enterprise Technology (e.g., Microsoft, Adobe)
- Semiconductors (e.g., Intel (NASDAQ:INTC), Nvidia (NASDAQ:NVDA))
- Industry specific tech companies – Fintech, HealthTech (e.g., Mastercard (NYSE:MA), Teladoc (NYSE:TDOC))
I believe industry-specific tech companies are more correlated to their specific sectors and should be discussed along with them e.g., assess fintech companies with financial services stocks. So, the focus of my article is on the first three categories – Consumer Technology, Enterprise Technology, and Semiconductors. I wish I had perfect ETF proxies for these categories, but I will make do with the following ones:
Consumer Tech – First Trust Dow Jones Internet ETF (NYSEARCA:FDN)
Enterprise Tech – iShares Expanded Tech-Software Sector ETF (BATS:IGV), WisdomTree Cloud Computing ETF (NASDAQ:WCLD)
Semiconductors – iShares PHLX Semiconductor ETF (NASDAQ:SOXX)
I am using two different ETFs for the enterprise tech sector as there seems to be a lot of interest in emerging cloud companies, and WCLD provides broad coverage of those. So without further delay, let’s look at how these sub-sectors have performed compared to Technology as a whole and SPY.
WCLD is a very new ETF so we don’t have its long-term performance, but as far as YTD performance is concerned, it has left all its technology peers in the dust. I guess you may have already guessed this, as all the emerging cloud stocks are going through a melt-up period. But leaving that on the side and looking at the 10-year performance, each of the sub-sector ETFs has outperformed SPY by a significant margin, so there is some value in unpacking them further. You would also notice that the performance differential is not that high between IGM and the sub-sector ETFs, so there is nothing wrong with a strategy revolving around buying the broad technology gauge and calling it a day. By the way, this performance is consistent over all the periods including 10 years, 5 years, 3 years, and 1 year. So before we drill down further, let’s have a quick look at what these ETFs/sub-sectors consist of.
Source: FDN, IGV, WCLD, and SOXX respectively
You would notice that all the ETFs (except WCLD) are fairly concentrated in their top 10 holdings, which is normal for a sub-sector ETF. WCLD is an equal weight ETF, so its weightings are more equally distributed, which is a good thing, as the point of investing in something like WCLD is to generate alpha through the performance of the smaller players. Now the reason I said these ETFs are not perfect because I don’t see Salesforce and Veeva (NYSE:VEEV) as internet play but more of enterprise tech names, so they belong in the latter category. Further, lines are blurring between hardware and software, so I do believe something like Apple (NASDAQ:AAPL) belonging to FDN.
Anyways, the whole point of going through this exercise is to get better clarity on why we are investing in a particular name and what may drive future returns. So let’s explore each of these subsectors a bit more, and if we understand the fundamentals of these holdings, we should get some perspective on the past as well as the future potential of these subsectors. Here is a snapshot of some key metrics of the top 10 stocks in each of these sub-sectors (made some adjustments for Consumer Tech e.g., dropping Salesforce, Cisco (NASDAQ:CSCO), Veeva, added Apple).
This list contains who’s who of the technology industry and most of these are household names. But that’s not it. Look at the mean return of ~32.7% CAGR over the last five years. It’s phenomenal. There have been a few duds such as Booking (NASDAQ:BKNG) and Twitter (NYSE:TWTR) but that’s it. And all these great returns are supported by incredible revenue and EPS growth. So the five stocks with 30%+ CAGR return over the last five years also have 15-30% revenue growth YoY. Keep in mind all these businesses have very low marginal costs so a big portion of the revenue directly flows to the bottom line i.e., revenue growth of 15% may mean EPS growth of 30% or even higher. One stock that is running more on multiple expansion than on revenue growth is Apple – its revenue and earnings are growing at ~6.5% and 12.7% respectively, but it has delivered 30%+ CAGR returns and is now trading at ~30 Forward P/E. Unless something changes dramatically, Apple may end up trading sideways for the next few years till earnings catch-up. So if not Apple than which ones are my favorite? I am listing these in my priority order.
Facebook (part of Consistent Compounders bucket) – I am not exaggerating when I say this – Facebook is the most undervalued large-cap tech stock period. If you don’t want to pay up for quality, go ahead, and buy Facebook. It’s expected to compound its earnings at ~26% over the next five years which means its 2024 earnings would be 3 times its 2019 earnings. All this and it still trades at mere 33-34X earnings. I wouldn’t be surprised if the Facebook stock crosses $500 as soon as next year.
Amazon (part of High-Flyers bucket) – I’d admit it. It took me a long time to understand Amazon’s potential because I kept looking at its high PE multiples and never realizing its cash flow generation capabilities. Based on TTM, it is only trading at 31 times its cash flow from operations. Further, they have grown their Operating Cash Flow @~31% every year (it’s ~40% for the last three years, so growth is not slowing), ~15X in 10 years. Isn’t that incredible? So I am more than happy to pay 30-60 times earnings for a business that can grow their cash flow at the clip of 30%. And if the stock price gets stuck at the current level for a couple of years, we would be looking at a business growing @30% and trading @~18 times cash flow, and that would make it even more attractive. Don’t miss this one.
Google (part of Consistent Compounders bucket) – Yes, it’s a bit more expensive than Facebook, and the growth rates are not as high, but Google will stay entrenched in our lives one way or another and continue to drive revenue with the shift of ad spending towards digital. So for me, it’s a clear Growth at Reasonable Price (GARP) play that can double over the next five years.
Netflix (part of High-Flyers bucket) – I recently wrote at length about Netflix here. Netflix’s ability to leverage global content, untapped potential to drive revenue from multiple mediums and proven management may cement its position as the top entertainment player. Not undervalued, but I’d be surprised if it doesn’t cross $1,000 over the next five years.
Booking (part of Consistent Compounders bucket) – It has been trading sideways over the last couple of years, but I do see a great business that will continue to compound earnings, and current valuations are super attractive. A hard recommendation in the current environment.
Enterprise Technology is a fairly large bucket, but think of it as any business that makes the life of other businesses easier through technology. They come in all shape and form, but you can primarily divide them between software and hardware, though the lines are blurring with the cloud. The proxy ETFs I used here are more focused on the software side of things so you may see names such as IBM (NYSE:IBM) and Cisco missing. I have also included two sets of tables to showcase IGV and WCLD holdings respectively. You may notice that I changed the columns a bit, as it’s better to look at them from price/sales perspective than earnings multiples at this moment.
IGV holdings – It’s tilted towards large caps. And you may notice, it has performed exceptionally well over the last five years, in fact, better than its Consumer Tech players. This is happening because every business is trying to transform how they operate and these tech players are the lifeblood of that transformation. You may also notice the consistency of returns (except Oracle (NYSE:ORCL), of course). So you can easily buy and hold IGV and let these cloud players do the work for you. If not, my favorites are – Adobe, Salesforce, Workday, ServiceNow, and Microsoft. Let’s go through them.
Workday (part of High-Flyers bucket) – If you compare the Current Price to Sales with Five-Year Average for any of these stocks, they have gone up. Means people are paying more as they are realizing the importance of these businesses. The only exception is Workday, as there is a perception that its growth is slowing. I don’t think so. Workday is continuing to expand its TAM by investing in new areas (e.g., Workday Student), and it has immense potential. At less than $200, it’s a steal.
ServiceNow (part of High-Flyers bucket) – My second favorite. Similar to Workday but the stock is expensive @~24x Sales compare to 12x for Workday. But its sales growth has been slightly higher, and people believe it will continue to be elevated. A good buy below $400.
Microsoft (part of Consistent Compounders bucket) – Don’t we all love Satya Nadella and what he has done with Microsoft. Microsoft is not cheap especially considering slower sales growth, but Satya has changed Microsoft’s image by positioning it to be a true business partner in the journey toward digital transformation, and that may continue to propel the organization forward.
Adobe and Salesforce (in my watch list) – Both of them are great businesses, though Salesforce seems to be cheaper. I do think Salesforce is a good buy at current levels, and Adobe would become one if there is a 15-20% pullback.
WCLD holdings – Folks, this is the wild west. There are many gurus who may tell what to buy and what not to. But no one knows what would work and what would not in the mid to long term. Every business here is trading at 30, 40, 50, or even 60-time sales. Are these fair valuation – maybe or maybe not. We would only know the true winners after the fact. Though, there is nothing wrong with buying the ETF itself with solid diversification across 60+ holdings at the expense of less than 0.5%. Personally, I own Shopify, but I bought it in the low 100s. The management is visionary, the business is extremely scalable and marginal cost is low – but would it continue to perform as well as in the past. I don’t know.
I also own Slack, PagerDuty (NYSE:PD), and Alteryx (NYSE:AYX) from this group. But honestly, I would advise to just buy WCLD and call it a day.
This bucket has also performed extremely well, but also notice the variation in returns between individuals stocks (from 8% to +114% CAGR for the five-year period). The 10-year period returns look better. The semiconductors are very cyclical and dependent on that star chip that carries the company forward. I don’t hold any of the semiconductor stocks just because I have no clue how to dissect these businesses. If you are from the space, and know it well, good for you. If not, one can either buy the ETF itself or something else where you have more conviction. The two stocks that I like from this space are a bit less cyclical – Texas Instruments (NASDAQ:TXN) and ASML Holding (NASDAQ:ASML).
Technology has driven the markets in the last decade and will continue to do so. Technology will underpin every incredible customer experience and can drive huge efficiencies for businesses. Looking within the sector, every sub-sector has performed very well, though Enterprise Tech is my favorite along with Consumer Tech companies. I have shared some of my favorite picks in both of these sub-sectors. You can check my full portfolio here.
If one understands the emerging cloud or semiconductors space well and can pick winners – that’s great. For everyone else, it might be better to either buy their respective ETFs or avoid them.
The more important piece is to ensure enough allocation to the technology sector as a whole, and it’s not as expensive as you may think. So if you don’t have enough energy to buy 10 different stocks form the sector – go ahead and buy IGM, and you will thank me in 2024.
By the way, you may have noticed that I didn’t mention COVID even a single time in the article. As long-term investors, we should not be considering these short-term concerns unless something has fundamentally changed. And for the Technology sector and sub-sectors and most of the players, I don’t think COVID has made any meaningful long-term impact – positive or negative – apart from accelerating some pre-existing trends that were.
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Disclosure: I am/we are long AMZN, GOOGL, FB, MSFT, NFLX, BKNG, WDAY, NOW, SHOP, AYX, PD, WORK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.