One of the prominent casualties of the European Union’s weak economy has been the U.S. information technology sector. The sector has lagged the S&P 500’s price recovery from the May lows. It now trades at a price-to-earnings ratio equal to the S&P 500, despite having what I believe to be superior growth prospects. In a sense, this is not an unnatural occurrence. Most American technology companies have substantial European operations, and demand for their products and services is somewhat linked to the level of economic activity there. They should feel the sting of European austerity, at least for a while.
Source: FactSet.
Past performance is no guarantee of future results.
Source: FactSet.
Past performance is no guarantee of future results.
I believe that this relative price weakness has created a buying opportunity for investors willing to look out several quarters and participate in a corporate technology upgrade cycle, which is well under way but far from played out. Corporations have already benefited from recent upgrades, but I believe that greater profitability can be achieved with the purchase of more hardware, software, and services. The great promise of the Tech Boom of the late 1990s is being fulfilled: The use of technology is making us all more productive and shortening the corporate feedback loop. However, as mentioned above, this is now occurring with the sellers of this technology trading at a valuation no higher than the market.
It is ironic that technological capacity follows a fairly predictable path. The speed of data processing rises and the costs of data storage fall at rates that vary little over a given period of time. The cyclicality of the business arises from the cyclicality of demand for technology, not supply. When new technology can enhance corporate profitability, the demand rises. When newer, better technology does not help the bottom line, demand stagnates.
During the Great Recession of 2007–2009, corporate technology upgrades took a back seat to cost cutting and retrenchment. Effectively, almost an entire tech upgrade cycle was skipped. Since then, corporate managers have been trying to catch up. I believe that the currently high level of corporate profitability is due to the fact that current and future employees have been made more productive by improved technology and that corporations can manage their businesses more tightly as technology tells managers of their successes or failures and allows them to adapt strategies accordingly.
To me, this virtuous cycle is not over. Bouts of sporadic economic contractions may delay upgrades, but I do not think they end them. Thus, with the sector having lagged for two quarters and returned to a non-premium valuation, I believe that it is a good time to accumulate the shares of large capitalization companies selling technology to other companies. I think that the good news is not over.
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