The Information Technology sector is having a banner year as it benefits in so many ways from the continued expansion of how we use the Internet and smartphones in our personal and professional lives.
Just consider the tech-induced shift in shopping habits that led more folks to make holiday purchases online last weekend instead of walking into a store. The market has come a long way since Amazon.com started selling books online in 1995.
Information Technology is the second-best-performing sector among the 10 S&P 500 sectors ytd, up 7.9% through Tuesday’s close and outpacing the S&P 500 by more than five percentage points.
Analysts are optimistic about next year as well. The sector is expected to post earnings growth of 7.2% in 2016 on 3.6% revenue growth. If analysts are correct, other sectors — including Financials, Health Care, Materials, and Consumer Discretionary — will boost earnings more rapidly next year, but Tech will turn in solid results nonetheless.
Let’s have a closer look at some of the recent developments that may continue to propel the sector higher:
(1) The Internet is hotter than ever. Moderate overall growth expectations for the Information Technology sector hide very large differences between the sector’s winning and losing industries. Tech industries having anything to do with the Internet — be it search, shopping, social media, or Cloud computing — are expected to grow earnings much more rapidly in 2016 than the overall Tech sector, and the related stocks are on fire.
The Internet Software and Services industry — which includes juggernauts Facebook and Google — is expected to have the fastest earnings growth in 2016, at 19.4%. With shares up 35.6% ytd, the strong growth expectations certainly aren’t a secret. However, the industry’s shares continue to be reasonably priced, with a 25.9 forward P/E.
The market’s enthusiasm is understandable. Facebook said that 1.55 billion people tap the social network at least once a month and about 1.01 billion checked it at least once a day in September, the 11/4 WSJ reported. That goes far in explaining why Facebook has become a darling of advertisers, helping to boost the company’s revenue 41% in Q3 to $4.5 billion. Joe reports that analysts expect Facebook to produce long-term earnings growth (LTEG) of 29.2%, making it one of the top-ten fastest long-term growers among companies in the S&P 500.
Just as Facebook dominates social media, Google lords over Internet search with market share of 63.9%, according to comScore. The company has grown to dominate email and maps, and aims to grow its Cloud services. Perhaps just as importantly, Alphabet, Google’s newly created parent, has a new CFO Ruth Porat who hails from Morgan Stanley and appears to be pushing the company to do grown-up things, like repurchasing stock and keeping costs under control. Alphabet announced plans to purchase nearly $5.1 billion of its shares, surprising investors and sending the shares higher, the 10/22 WSJ reported.
(2) Charging with Blockchain. The Data Processing & Outsourced Services industry is also outperforming the broader market, having risen 13.3% ytd (Fig. 9). While respectable, that result camouflages the much stronger returns of industry members that are enjoying higher transactions thanks, in part, to purchases made over the Internet. Visa is up 21.9% ytd, Mastercard 13.7%, and Total Systems Services, an electronic payment processor, 66.0%.
The Data Processing and Outsourced Services industry has a 23.0 forward P/E on expected earnings growth next year of 12.1%. The industry has sported a 22 forward P/E for much of this year, which is much higher than the multiple the industry has had over the last 10 years.
Down the road, those P/Es could come under pressure if the new technologies in transaction processing enter the mainstream. One that stands a chance is Blockchain. Last weekend, a Barron’s article explained how Blockchain could be used in the future to slash transaction costs. “Using a collection of computer codes, blockchain records credits and debits between parties. Whether the currency of those credits and debits is Bitcoin, dollars or renminbi doesn’t matter,” writes Tiernan Ray. “In a blockchain world, all transactions are just a software program running on computers distributed across the Internet, rather than the private ledgers of Banks.” In such a world, your Visa card is unnecessary.
(3) Playing games. The top-performing industry group within Information Technology is Home Entertainment Software, which includes video game publishers Electronic Arts and Activision Blizzard. The industry is up 64.3% ytd.
Investors were excited about Activision Blizzard’s introduction this year of “Call of Duty: Black Ops 3.” They also liked news that the company is establishing a production unit to turn its “Sklyanders” game franchise into a TV show and its “Call of Duty” games into movies. The company’s acquisition of King Digital Entertainment, maker of “Candy Crush,” was also well received because it will increase Activision’s presence in mobile gaming and expand its female audience. The launch of “Star Wars: Battlefront” game last month had Electronic Arts shares rallying in anticipation.
Despite its strong performance this year, the Home Entertainment Software industry trades with a 21.6 forward P/E, which isn’t unreasonable if its 15.2% expected earnings growth in 2016 materializes. The industry has had a forward earnings multiple as high as 30, in 2008.
(4) P/Es in the Clouds. The Application Software industry — driven by the Cloud businesses in Adobe and Salesforce.com — is up 23.7% ytd (Fig. 13). The industry has the dubious distinction of being the most expensive in the Tech sector, with a 40.7 forward P/E, more than double the 16.7% earnings growth rate forecasted for 2016. Like many areas in Technology, the multiple would be even higher if earnings reflected stock-compensation expense that analysts regularly exclude from operating earnings.
Adobe, for example, recently announced its fiscal 2016 non-GAAP earnings forecast of $2.70 a share and GAAP earnings of $1.80 a share. Analysts appear to be relying on the non-GAAP earnings to come up with a fiscal 2016 forecast of $2.79 a share, or 34.8% earnings growth. Adobe’s press release explains that GAAP earnings have been reduced by stock-based and deferred compensation expense of 78 cents a share in addition to other items. If operating earnings were reduced by the excluded compensation expense, it would fall to $1.92 a share, and the P/E would rise to 48.2 compared to the 34.3 multiple on operating earnings. Adobe and Salesforce.com also make Joe’s list of top 10 companies with the fastest LTEG rates. Adobe’s is 32.8%, and Salesforce’s is 31.0%.
News reports have questioned whether the big run in the FANG stocks (Facebook, Amazon, Netflix, and Alphabet, formerly “Google”) can continue. Netflix and Amazon.com are actually in the Consumer Discretionary sector, but their businesses are so intertwined with the Internet and technology that they invariably get lumped in with high-flying tech names.
An 11/30 Bloomberg article reported that Jefferies Chief Global Equity Strategist Sean Darby believes the FANG stocks will disappoint in 2016 as investors move into underperforming sectors of the market. That said, Jefferies recommends buying Facebook, Amazon, and Alphabet and has a hold rating on Netflix. Amazon.com has the fastest LTEG rate of any company in the S&P 500. Analysts have grown increasingly optimistic and now are forecasting a 60.4% LTEG rate, up from 35.5% just three months ago, Joe reports.
(5) Laggards as M&A prey. The Tech sector also has a number of industries that have fallen in value since the start of the year, specifically Communications Equipment (-12.8% ytd), IT Consulting and Other Services (-0.1), Semiconductor Equipment (-13.6) and Technology Hardware, Storage and Peripherals (-2.1).
But since the market’s August bottom, some of those Tech industry laggards have turned into leaders. The Semiconductors and Semiconductor Equipment industries were among the worst-performing sectors from the start of the year through the market’s August 25 bottom, down 21.2% and 33.3%, respectively. Since then, they’ve rebounded by 28.3% and 29.5%, helped by a slew of acquisition announcements in the industry. The spate of deals has given a bid to stocks in both industries.
The Systems Software industry, which includes Microsoft, also lagged going into the market’s summer bottom, down 15.1% during that time period. But since the market low, the industry has enjoyed a strong bounce, jumping 28.2%.
Most of these ytd laggards have much more reasonable P/Es but also much slower growth. The Semiconductors multiple is a below-market 15.7, but it’s only expected to grow earnings by 1.3% next year. The outlook for Semiconductor Equipment is better, with 9.5% earnings growth forecast but a forward P/E that’s a still-reasonable 14.6.
This past weekend, the New York Times ran an opinion piece titled “Addicted to Distraction.” It laundry-listed all of the ways that the author was distracted by the Internet, whether it be checking email, shopping, or clicking tempting headlines like “Awkward Child Stars Who Grew Up to be Attractive.”
Thanks to smartphones, we’re all too familiar with the distractions that come while sitting at our desk or standing online at the grocery store. As long as we all stay addicted to our devices and the World Wide Web, Information Technology should continue to thrive.
Posts by Dr. Edward Yardeni
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