Tech Stocks for Value Hounds

The tech sector isn't the exclusive domain of growth managers - the S&P 500 sports a 20% stake, after all - but relative to their blend and value counterparts, it is a favorite growth fishing hole.

Shannon Zimmerman 03.07.2012
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The tech sector isn't the exclusive domain of growth managers - the S&P 500 sports a 20% stake, after all - but relative to their blend and value counterparts, it is a favorite growth fishing hole. Growth funds are the biggest shareholders of bellwethers such as Apple and Google. The typical fund in Morningstar's growth peer groups has over a fourth of its assets (26.4%) in tech stocks.

Apple's recent evolution from R&D-focused cash-hoarder to modest dividend-payer, however, coincides with increased tech exposure among blend and, especially, value funds. Across Morningstar's value categories, the typical fund has allocated roughly 12% of assets to technology companies. That more than doubles the figure from five years ago (5.5%) and comes close to doubling the percentage from 10 years ago (6.1%). The increase has been especially pronounced among small- and large-value funds. For that subset, the five-and 10-year average tech exposures are 3.4% and 4.4%, respectively.

Tech Tea Leaves
Value managers don't invest in the tech sector, per se. They invest in individual firms that meet their stringent fundamental and valuation criteria and let the sector allocations fall where they may.

First, in the aggregate, tech stocks strike an attractive valuation profile right now. Even after the sector's recent runup, the typical tech fund's average P/E reflects just a modest premium relative to the S&P, and its average price/book and price/sales multiples currently fall below the S&P's. That's the case despite the technology peer group's much better growth measures. The typical tech fund's average sales, cash flow, and book-value growth metrics all trump the S&P's by wide margins--over 45 percentage points in each case. There's a similarly large gap between the market's and the category's historical earnings. On the theory that stock prices eventually follow earnings growth, the appeal of the technology sector for value hounds isn't hard to see.

Second, the sector's fundamentals should look especially attractive to investors who favor financially healthy firms that appear to be trading at steep discounts to their intrinsic value. In addition to its superior growth attributes, the typical tech fund's holdings are, on average, both financially healthier and more profitable than the broader market as gauged by the S&P. It has higher cash return and free cash flow yield figures, too--indications that the typical tech fund owns firms whose managers have put capital to work more efficiently and with above-average success.

It's true that, according to Morningstar's equity-research group, the percentage of firms with economic moats that reside in the typical tech fund's portfolio falls slightly below the S&P's moat percentage. Still, roughly 85% of that fund's assets are invested in firms that do possess sustainable competitive advantages (that is, economic moats).The figure for the S&P, whose companies enjoy wider moat coverage from Morningstar's equity analysts, clocks in at 91%.

Drift Away?
Attractive valuations and fundamental strength don't guarantee investment success in any particular market cycle. Indeed, during 2009's risk-fueled rally, solid profitability and robust financial strength worked against many companies and the mutual funds that held them. Moreover, most investors probably have all the technology they need, given that the sector accounts for roughly 20% of the S&P 500.

However, investors who may be scratching their heads over the level of tech exposure they're getting from their value and blend funds shouldn't assume their managers have drifted from their strategies to become free-spending buyers of richly priced growth stocks. These days, even deep-seated blue-light specialists should be able to find much that they like down the market's tech aisle.  

Shannon Zimmerman is an Associate Director of Fund Analysis at Morningstar.

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Shannon Zimmerman  Shannon Zimmerman is an associate director of fund analysis at Morningstar.

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