Tech Stocks Catching Earnings Signal Buy: EcoPulse

Shares of large-cap technology companies are poised to outpace the market as their stock prices are starting to reflect more stable demand -- illustrated by analysts’ earnings expectations.

The Standard & Poor’s 500 Information Technology Index -- with Apple Inc., Microsoft Corp. and 63 other members -- has risen 9 percent in the past three months, compared with a 4.2 percent gain in the S&P 500. That follows 18 months when the tech group lagged behind the benchmark index by 18 percentage points.

The shift reflects investors who see business improving for many of these companies, including those specializing in software or hardware, said Walter Todd, who oversees about $950 million as chief investment officer of Greenwood Capital Associates LLC in Greenwood, South Carolina.

“We recently started looking at some tech companies based on this premise: that their earnings are going to rise faster than the broader market,” he said.

Microsoft, the world’s largest software maker, reported today that second-quarter profit and revenue exceeded analyst projections, sending its stock up about 2.5 percent as of 4:30 p.m. in New York.

Widest Differential

The performance of tech stocks historically has tracked analysts’ earnings forecasts on a relative basis. This relationship broke down in the past year, reaching its widest differential in April. Now the gap is starting to close: Tech stocks are catching up with the earnings outlook, which has been relatively stable in the last three months, Todd said.

David Katz, who oversees about $975 million as chief investment officer at New York-based Matrix Asset Advisors Inc., anticipates industry expenditures will accelerate this year. That’s based partly on a forecast from industry researcher Gartner Inc. that shows total information-technology spending increasing 3.1 percent worldwide to $3.8 trillion, following 0.4 percent growth last year. The broad measure includes hardware, software and services.

“In a better global economy, with rising capital spending in the U.S.,” this year probably will favor “old technology” companies such as Hewlett-Packard Co., Cisco Systems Inc. and Microsoft, Katz said.

Improved Investment

The Federal Reserve Bank of San Francisco’s Tech Pulse Index, which tracks the health of the U.S. information-technology industry, is showing an improvement in investment, consumption, employment, industrial production and shipments. The index rose for a 10th consecutive month to 81.84 in December, the highest since 2008.

Three Fed districts -- Philadelphia, Minneapolis and San Francisco -- cited “increased growth in information-technology services,” with San Francisco seeing “strong demand for cloud services,” according to the Jan. 15 Beige Book business survey.

Against this backdrop, sentiment about companies that make products ranging from networking equipment to mobile-phone components also is rebounding, Katz said. “Any incremental improvements in fundamentals could move the needle and start pushing stock prices up quickly.”

The shares are part of a broader transition, as investors move into industries that typically outperform benchmarks later in an economic expansion, according to Brian Jacobsen, who helps oversee $236 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin.

55-Month Expansion

The current expansion began in June 2009, 55 months ago. The average since 1945 is 58.4 months, according to the National Bureau of Economic Research’s Business Cycle Dating Committee, which determines when recessions start and end.

That sentiment shift will benefit bigger tech businesses, because they have better fundamentals relative to the broader market, Jacobsen said. For example, the nine largest companies in the S&P 500 IT index -- which includes manufacturers as well as Google Inc. and Visa Inc. -- have a median return on equity of almost 23 percent, compared with about 14 percent for the benchmark index, Jacobsen said.

The tech index also is “more reasonably valued,” trading at about 15.5 times earnings now, below the 10-year historical price-to-earnings ratio of 16.4, Jacobsen said. He calculates the median for the S&P 500 is about 15.3, up from 14.1.

“Valuation and fundamentals will come together in the next three to six months to benefit large-cap tech stocks,” he said.

Index ‘Breakout’

The technology index has experienced a “breakout,” trading above highs set in June and November on a relative basis, said Jim Stellakis, founder and director of research at Greenwich, Connecticut-based research company Technical Alpha Inc. This shows investors are putting more money into these stocks, albeit very slowly, he said.

Phone-chip manufacturer Qualcomm Inc. is a “big fund favorite” attracting additional investment, while Cupertino, California-based Apple, maker of the iPhone, also is regaining favor, Stellakis said.

Todd’s firm has held Apple for more than a year -- even during periods when “the performance hasn’t been so great” -- and last week initiated a very small position in Intel Corp., he said. “We just dipped our toe into Intel on the premise that its business is turning.”

Missing Estimates

That decision came just days before the Santa Clara, California-based company reported fourth-quarter net income of 51 cents a share on Jan. 16, missing the 52-cent consensus of analysts’ estimates compiled by Bloomberg. The world’s largest chipmaker also said sales this year will be “approximately flat” with 2013’s $52.7 billion, below the $53.2 billion analysts’ projection. Intel shares fell 2.6 percent the following day, the most in almost two months.

These results haven’t dissuaded Todd, who believes Intel’s longer-term picture remains favorable.

“The quarter didn’t really change our view,” he said, adding that the stock rallied ahead of the announcement -- rising about 18 percent since Oct. 8.

Only about 20 percent of the S&P 500 tech-index members had reported earnings through yesterday, and their results have been mixed. International Business Machines Inc. said Jan. 21 that fourth-quarter earnings, excluding some items, climbed to $6.13 a share, above the analysts’ consensus estimate of $6. Meanwhile, total revenue for the Armonk, New York-based company slid for the seventh straight quarter, missing analysts’ projections by about 2 percent, based on data compiled by Bloomberg.

Record Revenue

Microsoft, based in Redmond, Washington, reported second-quarter earnings of 78 cents a share, more than 14 percent higher than the consensus of analysts’ projections. “We delivered record revenue as demand for our business offerings remains high,” Amy Hood, chief financial officer, said in a statement.

Apple is scheduled to announce fiscal first-quarter earnings on Jan. 27.

If analysts’ expectations for tech-companies’ earnings fall, it would indicate they don’t foresee a real improvement in demand, and “you have to believe that earnings are going to outpace the market for stock prices to move higher,” Todd said.

Gartner cut its forecast for global IT spending from a prior estimate of 3.6 percent, primarily because of weaker-than-anticipated spending on telecom services, Richard Gordon, managing vice president, said in a Jan. 6 statement. This segment makes up more than 40 percent of the total.

Targeted Picks

Katz says investors can select tech stocks by targeting segments that “lagged last year and are poised to play catch-up.” That’s why he likes companies such as Qualcomm, even though 2013 was “mediocre.” The San Diego-based company is the largest maker of chips for mobile phones, so it benefits no matter who wins or loses market share, he said.

Investors who have conviction in 2014 growth should look past results for the most-recent quarter, which could be somewhat lackluster, Katz said. “Our investment thesis is predicated on how the year plays out, and we continue to like technology into 2014.”