Bloomberg News

Tech Stocks Outperform as Excess Cash Beats U.S. Cyclical Risk

October 05, 2011

Oct. 5 (Bloomberg) -- Technology companies are outperforming the stock market as excess cash and cheap valuations attract investors amid rising concerns that the two- year recovery may be ending.

The Standard & Poor’s 500 Information Technology Index, which includes International Business Machines Corp. and Microsoft Corp., has fallen 3.4 percent since June 20, compared with with a 12.1 decline in the S&P 500 Index.

While it’s unusual for a cyclical industry to outperform when economic growth decelerates, “there’s probably a lot less downside here than in any other cyclical sectors,” said Doug Cliggott, a Boston-based U.S. equity strategist at Credit Suisse Group AG.

Strong balance sheets for technology companies may be “counterbalancing” the cyclical risk, according to Todd Coupland, an analyst at CIBC World Markets in Toronto. The industry may top $700 billion in cash on hand this year, trailing only financial services, he said.

“Having a big cash balance is defensive; it’s a buffer,” said Rick Campagna, chief executive officer of 300 North Capital LLC, who manages $500 million at the Pasadena, California-based investment firm.

U.S. gross domestic product climbed at a 1.3 percent annual rate in the second quarter, after almost stalling with a 0.4 percent gain in January-March, Commerce Department data show. GDP will rise 1.6 percent this year, according to the median estimate of 66 economists surveyed by Bloomberg News, after expanding 3 percent in 2010.

Mergers, Acquisitions

Some companies are using their cash for mergers and acquisitions as they try to “continue growth in the face of a slowing economy,” Coupland said.

Celestica Inc. completed its acquisition of the semiconductor-equipment contract-manufacturing operations of Chelmsford, Massachusetts-based Brooks Automation Inc. in June. This allows Celestica to maintain operating targets amid declining customer forecasts, said Coupland, who maintains a “sector outperform” rating on the Toronto-based electronics company.

In the absence of a potential takeover, the “preferred strategy” for companies with excess cash is to repurchase their stock rather than increase dividends, according to Coupland. Armonk, New York-based IBM bought back $4 billion worth of shares in the three months ended June 30, while Microsoft in Redmond, Washington, repurchased $1.3 billion during the same quarter and is planning a $40 billion buyback program that runs until 2013, the companies said in July. Both also have boosted their dividends.

Earnings Projections

Beyond health balance sheets, low valuations and modest earnings expectations are attracting investors, Cliggott said. Earnings are projected to grow 10 percent in 2012, compared with 16 percent for industrials and 14 percent for basic materials, setting the bar “low for tech stocks relative to other cyclicals,” he said.

Technology companies are trading at a multiple of about 12 times consensus earnings expectations for this year, similar to the S&P 500, whereas they’ve historically traded at a “modest premium,” he said.

“This mitigates downside risk for investors if the economy were to slow further,” Cliggott said.

A change in the business composition of the tech index has made it less economically sensitive, said Gina Martin Adams, an equity strategist in New York with Wells Fargo Securities LLC. Information-technology services are increasingly significant, representing almost 30 percent of the total market capitalization of the sector, compared with a five-year average of 10.8 percent, she said.

‘Stickier’ Services

“Services are just stickier,” Martin Adams said. “When there’s a cyclical correction, spending on tech services tends to decline less than hardware.”

Still, “there’s absolutely some downside risk” if the companies miss expectations when they report their earnings in mid-October, particularly given the recent outperformance, Cliggott said.

The earnings likely will be “very inconsistent,” as winners and losers emerge in the race to develop new, innovative products and services, Campagna said. He holds positions in Apple Inc. and Analog Devices Inc., which may be on “the winning side.”

The Cupertino, California-based maker of iPhones and iPads is up 18 percent since June 20; Analog Devices, the Norwood, Massachusetts, maker of chips used in cars, consumer electronics and telephone networks, is down 12 percent.

Neutral, Underweight

Managers may want to include some cyclicality in their portfolios if the economy rebounds soon, Cliggott said. The technology sector is his only “neutral” rating among cyclical industries; he maintains “underweight” recommendations on all the others.

Campagna is buying tech stocks now because there may be some “light at the end of the tunnel” in the economic slowdown. If growth stabilizes sooner than expected, these companies will continue to outperform the market, he said.

“Some tech stocks don’t look too risky because expectations aren’t that high and valuations are good,” Cliggott said.

-- Editors: Melinda Grenier, Daniel Moss

To contact the reporter on this story: Anna-Louise Jackson in New York at ajackson36@bloomberg.net

To contact the editor responsible for this story: Anthony Feld in New York at afeld2@bloomberg.net


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