US tech fundamentals healthy, but interest rates are a headwind
IT sector fundamentals are healthy, but interest rates remain a headwind. We offer thoughts on how to position IT sector holdings.
2022 consensus estimates move modestly higher
Overall results were positive as reflected in the upward revisions for calendar years 2021 and 2022 consensus estimates.
Revenue and net income for the sector were revised up by 66bps and 181bps, respectively, for 2021, reflecting better than expected 4Q21 results.
Consensus estimates for revenue and EPS in 2022 saw 153bps and 200bps positive revisions, reflecting healthy 1Q22 outlooks and CY22 expectations.
Consensus is baking in 9.4% reve- nue growth in 2022, but only 6.6% growth in net income due to higher interest costs and a modestly higher expected tax rate.
Index EPS growth is expected to be somewhat higher at 11.5%, outpacing net income growth largely due to expected share count reduction as companies repurchase their outstanding equity and a change in constituents/ weightings.
But the sector is firmly in correction territory. The IT sector is now -12.6% from the 52-week high despite rising estimates. The sector is now firmly in correction territory and seemingly just a few poor trading days from an outright bear market.
Fundamentals aren’t the problem...
Underlying the positive estimate revisions are healthy fundamentals. All major drivers of the IT sector appear to be on track. Enterprise spending should grow about 5%, according to industry analyst Gartner. Another industry analyst, IDC expects healthy smartphone demand in 2022, following growth in 2021 that could have been better if there had not been supply constraints.
...higher rates are
The IT sector’s P/E multiple has declined from 28.7x at the 27 December high to 24.3x, a haircut of 15%. We believe the approximate 47bps increase in the 10-year Treasury is a key driver, especially for “long duration” technology stocks.
Duration is a term typically associated with bonds: it measures the sensitivity of price relative to a change in interest rates.
The greater the duration, the more sensitive an asset is to changes in interest rates. Since the 27 December high for the IT sector, we have seen stocks with the highest valuations sell off more than their cheaper technology stock peers. We expect this dynamic to continue if interest rates continue to march higher.
While growth stock valuations can face further headwinds from higher rates, we think reasonably priced growth should be relatively less exposed. Furthermore, reasonably priced growth companies may have fundamental drivers of earnings and cash flow that can offset further valuation compression, with the net result being a stock that may trade sideways in a range as rates sort themselves out, but investors are still left owning high-quality businesses at reasonable prices when rates find a ceiling.
How to be positioned – more value, more mid-caps, more cyclicals
In terms of positioning, within the technology sector, we continue to prefer value over growth, mid-caps over large caps, and cyclical over secular.