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Key points:

  • As the economy closes in on completing its tenth year of expansion, technology companies have become increasingly prone to cyclical drawdowns, which is particularly worrisome given the sector’s rich valuations.
  • Though we do advocate a cautiously pro-risk approach to equity investing at this stage of the cycle, we examine below how not all tech is created equal. Some industries within the technology sector are more tied to the business cycle than others.
  • Understanding these different economic exposures may allow investors to better express their views on the business cycle and increase their exposure to structural trends.

Can tech’s outperformance overcome a slowdown?

Information technology is a driving force behind today’s economy. Earnings for the S&P 500 information technology sector have grown 14% annually since 2009, exceeding the S&P 500 by four percentage points.1 Fueled further by multiple expansion, and the sector outperformed the S&P 500 by 155 percentage points over the last 10 years, as depicted in Figure 1.

Figure 1: Technology sector and industries versus the overall S&P 500 over the last ten years

Figure 1: Technology sector and industries versus the overall S&P 500 over the last ten years

Source: Bloomberg, as of June 30, 2019.
Notes: Technology is represented by the S&P 500 Information Technology Index, Software by the S&P North American Software Index, and Semiconductors by the Philadelphia Stock Exchange Semiconductor Index. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

The proliferation of technology and related industries over the last ten years has transformed the way people interact with the world, how business is conducted, and how investors invest. The innovation that has allowed this to happen is enabled by a symbiotic relationship between rapid development in the sector’s backbone (semiconductors and hardware) and the adoption of the sector’s ever-evolving front end (software).

In order to facilitate further growth, companies must invest heavily in research & development (R&D) to uncover transformational improvements in technology. Figure 2 plots the top ten R&D spending industries in the S&P 500. Half of those industries are directly in the information technology sector. When considering companies formally in the S&P 500 Technology sector, (including the Facebook Amazon Apple Netflix Google (FAANG) contingent), that percentage moves to 70%.

Figure 2: Top 10 industries in the S&P 500 by research & development spending

Figure 2: Top 10 industries in the S&P 500 by research & development spending

Source: Bloomberg, as of June 30, 2019.
Notes: The trailing 12 month R&D expenditure is the sum of each company in the listed industries’ last four quarters of R&D expense. Blue bars indicate industries within the S&P 500 technology sector, orange bars indicate industries that contain FAANG companies, and yellow bars indicate other.

However, a broader threat of an economic slowdown challenges the market as a whole. This may be a particular headwind to cyclical sectors, which tend to have a higher vulnerability to economic conditions. This traditionally includes technology given their high sensitivity to market conditions. However, not all tech is created equal. We explore this thought below.

Separating the structural from the cyclical

All equity investments are susceptible to market risk, but the different business models, services, and products a company provides can help mitigate their sensitivity to these fluctuations. Within technology, we see a particularly interesting difference among the business models of semiconductors and software companies that give them different economic exposures.

Semiconductors: Semiconductors are the backbone of information technology as all products that require hardware (computers, smartphones, and appliances) use them. (Semiconductors have a “semi” conductive property that allows them to submit electric signals throughout a device to allow it to work.) In today’s economy, semiconductors are increasingly interwoven into the business cycle as their usage is deeply engrained into manufacturing systems, vehicles, aircraft, and other non-traditional information technology goods.

This broadened demand for semiconductors, but demand still tends to be cyclical. As the economy slows, consumers and businesses spend less on hardware, reducing demand for semiconductors, whose production cycles have to factor in considerable lead time. Figure 3 identifies how a commonly used indicator for the health of the U.S. economy, the Institute for Supply Management (ISM) Manufacturing Index, and the three-month moving average of global semiconductor sales have a high correlation.

Figure 3: Semiconductor sales and ISM manufacturing are highly correlated

Figure 3: Semiconductor sales and ISM manufacturing are highly correlated

Source: Bloomberg, as of June 30, 2019.
Notes: The ISM is a purchasing manager’s index (PMI) based on a survey of more than 300 manufacturing firms in the U.S. that evaluates the new orders, production, employment, supplier deliveries, and inventory trends. A PMI above 50 indicates expansion in the manufacturing sector, one below 50 indicates contraction.

Software: The investment definition of software, the programs that run and control the hardware, is ever evolving. In 2018, the most significant Global Industry Classification Standard (GICS) 1 reclassification in history occurred to better categorize software companies by their economic exposures.

Still, both traditional software companies and their former sector counterparts build applications that may be well positioned to capture the upside to information technology driven structural trends. These include:

  • The cloud: The "cloud" is a broad concept covering software as a service (SaaS), platform as a service (PaaS) and infrastructure as a service (IaaS). While SaaS is already being adopted by companies, PaaS and IaaS are still present nascent growth opportunities. The economics driving cloud migration are powerful and sustainable. Companies can access secure, scalable computing power on demand, and at lower costs than traditional IT systems. This is the power and scale needed to integrate sophisticated data analytics into business processes.

  • Data analytics: The growth of “big data” presents big potential opportunities. Today, as an estimated 3.83 billion people in the world have access to the internet, new data is being created exponentially2. Major advances in machine-learning algorithms, faster hardware and cheaper computing power are helping companies leverage unparalleled amounts of data. These companies are using analytics to automate operations, understand customer behavior and monetize data.

  • Digital media: Digital media usage is also accelerating – in 2018, adult digital media users in the U.S. spent 6.3 hours a day on mobile devices, desktops, or other internet connected devices.3 By the end of 2021, digital ad spending is estimated to reach 52% of total ad spending – up from 43.5% in 2018.4

  • Cybersecurity: As the importance of data increases for both companies and governments, the threat of hackers and data breaches has subsequently risen. Institutions are increasing security budgets to keep up with this threat; revenue of U.S. based cybersecurity companies is expected to increase by 8.6% in 2019, and 13.3% in 2020.5

Balancing risk and reward in the complex world of technology

As the economy enters its final stage in the cycle, cyclical sectors are likely to be at the forefront of investor worries. Though hardware/semiconductors and software companies need each other to push the boundaries of innovation, here are four points to consider when it comes to balancing structural technology from the more cyclical pockets.

  1. Software has a lower “beta” to the market than broad tech sector and semis.6 Though software demand does tend to be cyclical, we note that software companies’ beta to the broader market is lower than their semiconductor counterparts. The S&P North American Expanded Technology Software Index has a beta of 1.06 while PHLX SOX Semiconductor Sector Index one of 1.5. Additionally, this sensitivity appears more pronounced on the downside7. During the worst weekly declines of the S&P 500 over the last 10 years, the software sector has outperformed the overall S&P 500 Index by more than five basis points (bps, or .05 percentage points), while semiconductors have underperformed (Figure 4).

    Figure 4: Performance of technology sector and industries in the best and worst sessions of the S&P 500 over the last three years

    Figure 4: Performance of technology sector and industries in the best and worst sessions of the S&P 500 over the last three years

    Source: Bloomberg, as of June 30, 2019.
    Notes: The chart shows the average performance in excess of the S&P 500’s select weekly returns. “Upside” – performance in excess of the S&P 500’s return - was selected as the top 10 weekly performances of the S&P 500 over the last 3 years, while “downside” – performance below the S&P 500’s return - is the bottom 10 weekly performances of the S&P over the last 3 years. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

  2. Software is asset light: Software companies typically have lower inventories, fixed and total assets than their semiconductor counterparts. This is advantageous because it can keep companies agile and focused on their scale, and minimizes their fixed costs and reliance on manufacturing processes (which can be slower to adjust).

    Figure 5: Software companies tend to be more asset-light than their semiconductor counterparts on average

    Figure 5: Software companies tend to be more asset-light than their semiconductor counterparts on average

    Source: Bloomberg, as of June 17th, 2019.
    Notes: The bars represent the average ratios of companies in the Philadelphia Semiconductor Index (semis) and the S&P North American Expanded Technology Software Index (software). PPE stands for Property, Plant, and Equipment.

  3. Software companies are more richly valued than their semiconductor peers: The appreciation in software industry stocks has pushed up the valuations of these companies. The software industry now trades at a 12 month forward price-to-earnings (PE) multiple of 32x, about 15% more expensive than its 5 year average.8 Compared to the S&P 500’s PE ratio of 17x, this is quite expensive. However, when adjusted for forward expectations of earnings growth, the industry looks fairly valued with respect to the S&P 500, as both have price-to-earnings growth (PEG) ratios of 2.1x9. According to Bloomberg estimates, software’s long term earnings growth is 15.4%, a reasonable assumption given the sector’s historical growth rate and the industry trends detailed above.10

    Figure 6: Technology stocks are expensive compared to their history and the S&P 500, but are more fairly valued when adjusted for growth

    Figure 6: Technology stocks are expensive compared to their history and the S&P 500, but are more fairly valued when adjusted for growth

    Source: Bloomberg, as of June 17th, 2019.
    Notes: Data from 2014 – 2019. A z-score is the number of standard deviations from the average a data point is within a specific range. The PEG ratio is a company's stock price to earnings ratio divided by the growth rate of its earnings. It is used to determine the stock’s value while also factoring in the company’s expected growth.

    In contrast, semiconductors look fairly valued, as valuations are low on a relative, absolute, and growth adjusted basis. However, semiconductors tended to trade at a discount to the overall market over the last five years. A potential reason why is the naturally higher realized volatility in semiconductor stocks. Semiconductors have a 3 year volatility of 22%, six percentage points higher than their software counterparts and 10 percentage points higher than the S&P 500.11

  4. Geopolitical risks: Like many cash-flow and growth generating resources throughout history, information technology has come to the center of geopolitical confrontation and has borne the brunt of regulatory scrutiny. However, these risks will likely impact the various pockets of the technology sector differently. Several key geopolitical risks to monitor when it comes to tech’s idiosyncratic risks are listed below:

    • Sino-American tensions: Intellectual property behind semiconductors is at the center of the recent economic standoff between the U.S. and China. Security concerns are the overt objective, but the U.S. is also fighting to maintain its position as the global standard-setter for technology and innovation, as well as the leader of the free internet. Pushback in Europe and Asia may cause the U.S. to intensify its campaign. A decline in economic cooperation between the two nations, and an increasingly hostile tone to the race for technological supremacy, has negative ramifications for the industry, as seen in the decline in sales throughout 2018.

    • General Data Protection Regulation (GDPR): The E.U. has instituted a comprehensive regulation in order to increase data privacy and protect against data breaches. Several key aspects of the regulation are the requirement data collectors (tech companies) to obtain consent of the user before processing the users’ data and increases the ability of individuals to have their data erased. Companies that breach GDPR can be fined up to 4% of annual global turnover or €20 Million (whichever is greater)12. Though this is a headwind to the business models of some Platform as a Service companies, the regulation provides an opportunity for cyber security companies given the increased security requirements.

    • U.S. federal antitrust probes: “Big tech” – traditionally companies of the FAANG cohort – has come under increased domestic political scrutiny. On June 3rd, the U.S. House of Representatives launched a bipartisan anti-trust investigation against the country’s largest tech companies. Allegations that “big tech” is responsible for anti-competitive, free-speech limiting, and anti-privacy practices will likely be a central political bargaining chip heading into the 2020 U.S. elections. This is mostly a threat for large players in the interactive media and hardware spaces.

Conclusion

We believe portfolio resilience is crucial at a time of elevated macro uncertainty. We define resilience as the ability of a portfolio to withstand a variety of adverse conditions –both on a tactically defensive basis and strategically across cycles. This includes a careful examination of investor’s technology positions in their portfolio. The risks to the global economy, from decelerating growth to trade protectionism, puts technology sector investors on high alert.

While semiconductors and software companies need each other to push the boundaries of technological innovation, their differences give them different economic exposures. Though the software industry's high valuations may make it vulnerable to profit taking, the industry benefits from innovative structural tailwinds that will likely prevail through market cycles. The cyclical component of semiconductors cannot be condoned, but the need for faster processors and higher quality hardware also underpins their long-term attractiveness. Additionally, in the event that economic growth rebounds from its recent slide and trade tensions moderate, semiconductors may enjoy a “relief rally.”

Christopher Dhanraj
Director
Head of iShares Investment Strategy
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