Cheap Tech Redux: Sifting Through the Bargain Bin Again
A year ago, TMT stocks set a 20 year P/E low relative to the S&P500. Since then, tech has rallied back almost halfway to its historical relative P/E. However, the rising tide is not lifting all boats, with the dispersion of returns wide and a few big winners driving the sector performance. In June, we identified 26 large cap TMT stocks with cash adjusted forward P/Es below 10 and FCF yields above 10%. This group underperformed the S&P by 580bp and TMT by more than 970bp since June, flagging the risks of bottom fishing in the TMT pool. The 7 companies that screened as well on positioning against future opportunity and exposure to old paradigms appreciated more than 20%, while the 6 rated poorly fell -4.8% on average. Widening the 10/10% screen to include companies with <12x P/E and >8% FCF yields gives a new bottom fishing pool of 24 names. Using the same screens yields 6 attractive candidates and other 6 viewed as unattractive.
TMT is coming back, but performance has been concentrated, with a wide dispersion of returns relative to the S&P. Excluding 1998-2003, the average tech P/E has been 1.19x the S&P500. 800bp of outperformance YTD has raised the relative P/E of the S&P tech components from 0.99x to 1.06x. Meanwhile, performance has been widely dispersed, with the outperformance of a handful of megacaps driving cap weighted average returns 28% higher than median performance.
Bottom fishing has been treacherous – TMT stocks with <10x P/E and >10% FCF yields have broadly underperformed since June. Cheap tech stocks have always been something of a sucker’s bet. Historically, TMT stocks in the bottom P/E quintile have underperformed the top quintile by 640bp over the next 12 months. The 26 members of the 10/10 club that we identified a year ago June returned -0.3% since, vs. 5.5% for the S&P 500 and 9.4% for all of the TMT stocks in our universe.
We believe that the companies best positioned to exploit the once-a-generation paradigm shift will prove to be the best investments in the TMT sector. Specifically, we believe that portable devices using wireless networks to connect to distributed CDNs serving cloud-based, socially linked applications in an integrated user experience are quickly becoming the dominant consumer platform. Similarly, we believe that enterprises will increasingly adopt portable platform architecture and cloud-based infrastructure to improve IT efficacy and reduce costs. These changes will have negative implications for traditional TMT products – PCs, data center IT, and channelized TV amongst them.
Screening those cheap stocks for relevance against our long term sector vision yielded 7 that strongly outperformed, while 6 rated as risky performed very poorly. In June, we highlighted MSFT, CSCO, SYMC, SNDK, STX, WDC and FLEX as relatively well positioned for future opportunities and relatively insulated from old paradigm risk. These companies appreciated 22.4% since. At the same time, the 6 stocks flagged as poorly positioned and at risk from change – HPQ, DELL, CA, CSC, INTC and MU – fell -4.8% on average.
Widening the screen to <12x P/E and >8% FCF yield, leaves a pool of 24 bottom fishing candidates. With the overall market appreciation and with several of last year’s list falling off for losses and/or negative cash flow, the 10/10 club now has just 9 members, with Symantec, HP, RIM, Xerox and Pitney Bowes returning for a second time. Expanding the criteria to include companies with cash adjusted forward P/Es below 12x and cash adjusted FCF yields greater than 8% brings the pool back to 24 companies, with multiple media, advertising and cable/satellite names new to the list. Our screening process yields 6 well positioned companies and 6 viewed as having significant risk.
For the full research note, please visit our published research site.