Artisan Partners’ Sertl on US large caps and technology
George Sertl, US Value Team portfolio manager at Artisan Partners, comments on the opportunities by US large caps in the technology sector.
The technology sector is traditionally thought of as a growth sector. Given its reputation for innovative high-growth companies, it may seem counterintuitive that the sector is proving a fertile hunting ground for value investors that look for cash-producing businesses in strong financial condition that are selling at undemanding valuations. However, the technology sector is hitting all three of those investment criteria.
When people think about US technology stocks often what comes to mind is the technology bubble of the late 1990s and early 2000s and the companies that were selling at sky-high valuations despite unproven business models. The sector was priced very high, and many companies lacked financial discipline. Many of the start-up technology companies in the 1990s were primarily focused on rapidly building market share around new and largely unfamiliar concepts and technologies, which typically required large amounts of capital expenditures.
The capital intensive nature of starting those types of businesses was spurred even more by venture capitalists who were less discerning about the quality and long-term sustainability of a business model and more concerned about the potential for record-high stock valuations. As a result, unproven business models were the norm of the “growth over profits” mentality as companies tried to expand their customer bases as quickly as possible at the expense of profits.
The sector has matured quite a bit since then. Following the tech bubble, many management teams learned to refocus on return on capital and became more shareholder-friendly. The technology sector is much less capital intensive than it was and has higher cash flow margins, leading to higher returns on invested capital.
Companies are returning cash to shareholders through dividends and buybacks and abusing shareholders less with issuance of stock options. Fundamentals within the sector are vastly improved in terms of better financial health, profitability and cheaper valuation levels. At one time, the technology sector was selling at a big premium to the market.
In 1999, the sector sold for over 50 times earnings. Today, it is closer to 17 times, about in line with the broader market. Compared to the broader market, the technology sector has a lower long-term debt-to-capital ratio, higher return on equity, and an in line price-to-earnings ratio. So you are getting above-average quality for about the same valuation.
The US technology sector offers diversified exposure to the overall economy. Most technology companies will have some combination of exposure to the enterprise (business and government) or the consumer. As it relates to enterprise spending, we think of technology as modern-day capital expenditures that are integral to the operations of most businesses. Much of this expense is not discretionary, and we believe companies will continue to spend on productivity enhancements. From this standpoint, technology businesses are not too different from industrial companies that produce capital equipment.
IBM and Oracle are two examples of companies that fit this mould. Other technology businesses, such as Apple are focused instead on consumer end markets. Apple has a strong global consumer brand with most of its sales generated in its mobile division. In this vein, it could be compared to leading US consumer brands such as Nike, Tiffany and Ralph Lauren. When you compare Apple to these consumer businesses, we think it’s an as good or better business, even as it sells at a much cheaper valuation.
Within the technology sector, the risk/reward looks particularly interesting within the mega-cap segment, defined as a market capitalization of at least $100 billion. Many of these are household names. In addition to previously mentioned IBM, Oracle and Apple, other examples are networking equipment leader Cisco Systems and Microsoft, the largest software company in the world. These mega-cap companies have dominant market positions, global reach and technological leadership.
Despite superior business economics and balance sheets, they each trade at below-average price-to-earnings multiples in the low-to-mid teens. Some people have written these companies off as future dinosaurs and even that is still open to debate, but they are being priced as though they are closer to extinction than we believe they are.
In summary, US technology stocks have a quality advantage compared to the broader US equity market. The risk/reward is particularly attractive in the mega-cap segment where you can find several leading global technology companies selling at undemanding prices.