The information technology sector has had a rough month, as some high-profile earnings misses and elevated concerns over global growth have conspired to push the sector lower. While we aren’t downgrading our outperform rating on the sector, we are putting it on watch for a possible downgrade. We believe the sector is at an inflection point in which increased demand for technology will have to come from businesses, and not just the consumer. For now, patience is the key, but we’ll be watching developments over the next month or two to see where business spending on technology is trending.
One key item to watch for the tech sector is where business confidence heads. Despite a slight rebound in the most recent reading, The National Federation of Independent Business (NFIB) continues to report that optimism is relatively low, while the percentage of business owners planning capital expenditures over the next three to six months also continues to be weak.
Business confidence appears tentative
Source: FactSet, National Federation of Independent Business. As of 5/4/2016. The NFIB (National Federation of Independent Business) Small Business Optimism Survey which is based on the responses of 740 randomly sampled small businesses in NFIB’s membership, surveyed monthly.
This feeds into what we’ve seen since the Great Recession—companies have been reluctant to make capital expenditures, preferring to add to labor costs, which would be easier to shed if the economy takes another downturn. The level of capital spending compared with corporate revenues continues to run below the historical average, according to ISI Evercore Research. It appears that companies are spending when it is absolutely necessary, but are not making larger investments that would spur better long-term growth.
We believe this has to, and will, change in the near future. Technology advances quickly and can provide greater efficiency and productivity, helping companies compete in this global environment. A tightening labor market and increasing minimum wages in numerous areas of the country are also making it more expensive to hire new workers. In fact, we’ve heard anecdotal stories from companies within different industries, such as fast food, grocery and various manufacturing facilities, that are increasingly looking for tech solutions due to the higher wage and health care costs of human workers. Additionally, productivity growth has been relatively weak throughout the recovery and tech should help to improve productivity by allowing current workers to produce more.
Wage costs are starting to show rising pressure
Source: FactSet, U.S. Dept. of Labor. As of 5/10/2016.
While productivity growth is weak
Source: FactSet, U. S. Dept. of Labor. As of 5/10/2016.
While businesses have held back on technology investments, much of the rest of the fundamental picture for the tech sector looks pretty good to us. In an era where many stock valuations are elevated relative to their historical averages, valuations for the tech sector are more in line with their traditional levels. Strategas Research Partners points out that tech’s forward price-to-earnings ratio relative to its 15-year average is the lowest out of the 10 sectors.
Additionally, the tech sector has been buying back shares at a relatively rapid rate. Buyback announcements for the tech sector totaled $33.2 billion in the fourth quarter of 2015, according to FactSet. This represents a 5.2% increase in buybacks from the level a year ago, and marks the second straight quarter during which technology led all other sectors in buyback levels. This should help to provide a tailwind for the sector. Reducing the total share count through stock buybacks increases the earnings per share for remaining outstanding shares. A reduced number of total outstanding shares can also improve supply-and-demand dynamics for a given stock, which can result in a rise in share prices. . An increasing number of tech companies are also initiating or boosting dividend payments and they have the cash on their balance sheets to continue to do so, which we believe will be an important part of equity returns in the coming years.
Technology continues to be at the center of the American and world economies, in our view. Driverless cars, drones, smartphones, medical technology and many more innovations we don’t even know about yet are potentially exciting developments that have huge potential. This is one major reason we continue to be bullish on tech. However, over the past couple of years the consumer has carried a large load of technology demand. While we certainly think the consumer will continue to be interested in tech gear, it seems to us the next surge needs to come from the business side and that’s what we’ll be watching over the next couple of months.
Brad Sorensen, CFA, is managing director of market and sector analysis at the Schwab Center for Financial Research.