On the cutting edge
15 Oct 2005
Technological innovation helps economic growth. Some tech companies can help your portfolio, too.
Technological innovation leads to products that help to increase worker productivity, lower corporate costs, and enhance firm profitability. Just think about how much more work can get done now that companies have adopted computers in the workplace. Tech innovation also leads to products that are great toys for consumers of all ages - stereos, digital cameras, digital audio devices, and so on. This week, the Reuters Select Top Down article series looks at companies in the Technology sector. Today, we briefly discuss some of the trends impacting this group. In the coming week, we will discuss a handful of Technology companies, which recently appeared on at least one Reuters Select stock screen.
On a weekly basis, Reuters Select Top Down articles highlight a sector, industry, or other economic segment. Unlike the Bottom Up articles, which focus on a particular screen, and discuss some of the companies that appear on that screen, the Top Down articles focus on a particular segment of the economy, and then discuss some of the companies from that segment that appeared recently on any Reuters Select stock screen.
Note: You can click here to download the free Excel users' console spreadsheet that accompanies this article. It contains detailed performance information about the screens, identification of which other screens or risk alert signals are applicable to each stock, and it has tools to help you prioritize among the stocks making the screen and value each one based on trends and prospects for EPS and/or Sales per share.
How Big?
We last discussed the Technology sector back in March, beginning with the article Thinking About Technology on 3/19/2005. In that article, we pointed out the importance of tech advances in business activity: Technological advances are a driving force underlying economic growth. Enhancements to technology boost productivity. This enables people and businesses to perform tasks more efficiently, thereby requiring fewer resources to perform the same amount of work. With fewer resources utilized for the same amount of work, the "extra" resources are then available for production of other things.
Before we get to some of the trends in the Technology sector, we should take a moment o consider some of the different aspects of this arena.
The Tech sector is actually quite broad. Ask someone what comes to mind when they are asked to think of tech and they might think of semiconductors, software, computers and the like. This is accurate, but there is more to the story. The Technology sector consists of different industries ranging from Communications Equipment to various Computer-related segments to Electronic Instruments & Controls and even Office Equipment.
Since there are different facets to the Tech sector, there are many different stock indices that investors will probably want to watch. For example, there are the Philadelphia Semiconductor Index (SOX) and the AMEX Computer Technology Index (XCI), among others.
Tech Trends
As we pointed out, there are many different industries within the Tech sector, and we don't have the time to hit on every segment, but we should touch on a few just to get a general feel for some of the recent trends.
Looking at the trailing twelve-month (TTM) span, we see that the SOX has not really moved much. The roughly 7% climb there has been pretty steady, particularly when you stack it up next to the S&P 500 Index and the NASDAQ, which have posted similar returns, but with much more volatility. Meanwhile, the XCI has tracked the performance of the S&P 500 Index and the NASDAQ more closely.
When looking at the Tech sector, you can look at this from the perspective of individuals (consumers) and businesses. From the point of the view of the consumer, let me start by pointing out that personal consumption spending is roughly 70% of gross domestic product (GDP). Personal spending waxes and wanes with economic cycles, as people's sentiment toward their employment outlook and prospects rises and falls.
Generally, speaking, personal spending has remained quite solid of late, though there are some factors at play that suggest consumer activity will ease a bit in the near to intermediate term. How such an action will impact consumer tech products depends on the product.
When talking about consumer tech products, look to things like home computers, mobile phones, and other home electronics. You might not think of many of these products as tech items at first, but think about all of the items that you have and use every day that need semiconductors to operate.
First, think of the home computer market. There are a couple of companies to watch here, including Dell Inc. (DELL), which ranks among largest computer manufacturers in the world. Reportedly, DELL sold computers to more than 6 million customers last year. DELL, looking for growth opportunities in other areas, has expanded its product line to include things like digital music players and televisions. (We last discussed DELL in an article that Paul DeMartino wrote back on 06/17/2005.)
Another computer company that has gained a lot of attention of late because of success it has received from its enhanced product line is Apple Computer Inc. (AAPL). AAPL computers have enjoyed some success with certain markets - the design guys in our group love them - but it is the company's other products that have wide-reaching appeal. Specifically, take a look at the iPod.
The iPod has about 75% of the portable digital player market, which includes MP3 players. Even though there is some concern over iPod sales (despite jumping, they just didn't jump high enough for Wall Street), the company has recently released the Nano, which is a smaller audio player. Further, AAPL recently announced that a video-playing iPod is in the works and that it has penned a deal with The Walt Disney Co. (DIS) to sell TV shows after they have first aired. Here's the best part, this includes some of today's more popular TV shows, including "Desperate Housewives" and "Lost." Reportedly, the entire first seasons will be available immediately, at a cost of $1.99 per episode. (We last discussed AAPL in an article that Paul wrote recently on 08/23/2005.)
While we are talking about computers, let's take a moment to think about the stuff that makes a computer work. More specifically, consider the semiconductors that are needed. One of the largest players in the chip arena is Intel Corporation (INTC). In fact, as Paul pointed out in his 09/19/2005 article on INTC, the company is the largest semiconductor manufacturer in the Reuters universe, almost three times as large in market cap as the next largest. INTC's chips are found in DELL's computers, both desktops and laptops (and in some of AAPL's products, as well). In addition, INTC's Centrino wireless technology has enabled many notebook users to remain connected to their networks even as they move around the office for different meetings.
We've looked at the Tech sector from the consumer end; now let's consider it from the business perspective. After all, try to think of a business that doesn't use technological products to at least some degree. You're going to be kind of hard pressed to find some. And remember what we said earlier about how tech helps improve worker productivity and lower costs. Thus, there really isn't too much of a surprise in finding out that companies invest a considerable amount in things like equipment and software. Just to get a general idea of what we're talking about here, investment in equipment and software (this includes information processing equipment, computers and peripheral equipment, software, etc.) accounted for roughly 80% of total non-residential fixed investment in the second quarter of this year, according to GDP data from the Bureau of Economic Analysis, US Department of Commerce.
The drop off in investment spending, particularly in equipment and software, contributed to the bursting of the tech bubble several years back. It wasn't until 2003 that investment spending in equipment and software turned positive (for the whole year), and it wasn't until last year and investment really picked up, climbing 11.9%.
Although the rate of improvement in investment spending eased in the first quarter of this year, it did pick up in the second quarter. Following rates of 15.5% and 12.4% in the third and fourth quarters of last year, respectively, investment spending climbed at a seasonally adjusted annual clip of 8.3% during the first three months of this year. Yet, in the second quarter, the rate of growth climbed to 10.9%. Unfortunately, we still have to wait a couple of weeks for the government to post the third-quarter numbers.
Given that the amount that companies are willing to invest depends to some degree on expectations about future business conditions, it is likely that business investment spending will not pick up too much over the near to intermediate term. Figure, higher borrowing costs as a result of the Federal Reserve's series of interest-rate hikes, combined with higher energy-related costs, suggests that managers will probably continue to keep an eye on budgets.
Think of it like this, if a company previously thought about adding 15 workers so that it could keep up with improving business, but then saw that business did not improve as much as anticipated and now plans to add only 12, that means that the firm will also need fewer computers, headsets, and the like. Thus, we see that there is still growth, but there is easing in the rate of growth.
With that background in place, let's take a few moments to consider a couple of the Technology stocks that came across the Reuters Select stock screens recently.
A Couple Of Stocks
In a week when we are talking about Technology companies, it is nearly impossible for us not to discuss one of the key Internet companies. Yahoo! Inc. (YHOO), a Computer Services company, recently appeared on three Reuters Select stock screens from two areas. In the Quality segment, YHOO registered on the screens for Industry Leaders and Strong Operating Margins. And, from the Sentiment arena, YHOO, came to light on the screen for Consensus Choices.
YHOO's revenue growth rate exceeds the Industry norm over both the last five years and the trailing twelve-month (TTM) period. Ditto for its EPS growth rate. Further, both have accelerated of late from their respective longer-term averages. As with its brethren, YHOO's profit margins have widened of late, yet the company has maintained a relative advantage. The company does not pay out a dividend. YHOO seems to have relatively less debt than its peers.
Regarding its valuation, YHOO is a mixed bag. By some traditional metrics, such as price to earnings (P/E), P/Book Value, and P/Cash Flow, YHOO is priced at a discount to its peers. But, its P/Sales and P/Free Cash Flow measures put YHOO at a premium. The company's PEG (forward P/E relative to long-term EPS growth rate) ratios are quite lofty, especially when you consider the consensus EPS estimate for this year, indicating that it is probably better suited for somewhat more-aggressive investors.
Next, we have Thermo Electron Corporation (TMO), which is a leader in the Scientific & Technical Instruments category. TMO caught our attention when it appeared on two Value screens and one Sentiment screen. From the Value category, we noticed TMO on the screens for Favored Value Plays and Relative Value; from the Sentiment group, TMO was found on the screen for Consensus Choices.
TMO's revenue growth rate has accelerated of late from its longer-term norm, but remains below the Industry mean. The story changes, though, when one considers the company's EPS growth rate, which, despite easing of late, remains much faster than that of its peers. As with its brethren, TMO's Net Profit Margin has widened of late; yet, the company maintains a slight lead. The company does not pay a dividend. TMO has relatively less debt on its books when compared with the peer average.
Regarding its valuation, TMO is priced at a discount to its peers by many traditional metrics: Its P/E, P/Sales, P/Book Value, and P/Cash Flow ratios are all below the respective Industry averages. But, its P/Tangible Book Value and P/Free Cash Flow measures are higher. TMO's PEG ratios are above parity - too high for the most ardent Value investors, but are still reasonable.
Well, those are a couple of examples of the types of Technology stocks that one can currently find on the Reuters Select stock screens. In the coming week, we will look at a handful of such companies in a bit more detail.
What did you think of this article? Let me know.
This article launches our top-down investing strategy for the week ahead: Reuters Select Technology.
Also, be sure to check today's other strategy article introducing the bottom-up theme for the coming week: Reuters Select Growth.
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