Tag Archive: technology

Tech fundamentals still favor Hardware over Software

While the Technology sector has been less dominant in terms of returns this year than it was last year, it remains the largest sector in the US market by value and the focus of much investor attention.

Our view within the Technology sector for some time now has been to favor hardware-related industries over software-related or services areas, and the latest update of both bottom-up and top-down indicators continues to support this view.

The table below shows some of the key bottom-up fundamental metrics we track for all sectors and industries, and focuses on the six US Technology sector industries (using the GICS industry classifications) within our broad 2300-stock US universe.

The revisions breadth measures shown in the table are based on the proportion of analysts covering each stock who have raised their earnings estimates over the last three months net of those who have lowered earnings estimates. That is, the number of upward revisions to estimates minus the number of downward revisions relative to the total number of analysts covering a stock. We use a weighted average of estimates for each company’s current fiscal year (2021 for most companies right now) and next year (2022) to calculate a consistent 12-month forward earnings figure.

Source: Mill Street Research, Factset

The first column shows the average breadth reading for all stocks in each industry on an equal-weighted (“EW”) basis, while the second column shows the same data on a cap-weighted (“CW”) basis. Naturally, the cap-weighted figures give much more weight to the largest stocks in each industry, while the equal-weighted figures will be relatively more tilted toward smaller names. All stocks in our US universe require a minimum market capitalization of $200 million and at least three analysts reporting estimates, among other criteria, so there are no micro-caps or stocks with very few analysts included.

A few key points jump out from the table:

  • Revisions remain net positive in most areas of Technology, in line with the broadly positive revisions activity in US stocks overall.
  • The average revisions breadth readings on a cap-weighted basis are higher in every industry than the equal-weighted readings, and often much higher. The sector-wide average of about 51% far exceeds the equal-weighted average of about 19%. This means the largest Tech stocks have much more positive analyst activity than the average stock in the sector, i.e., a big-cap bias.
  • The strongest industries are those which focus on hardware right now, while software and services industries are substantially weaker.

We see that on an equal-weighted basis, the Technology Hardware, Storage & Peripherals industry has the highest proportion of positive revisions, followed closely by Electronic Equipment, Instruments & Components and then Semiconductors & Semiconductor Equipment. All three of these hardware-related industries also have the highest revisions breadth on a cap-weighted basis.

At the bottom of the list we see the large Software industry, which has marginally negative net revisions breadth on an equal-weighted basis. This means the average Software stock has a roughly equal number of analysts raising versus lowering estimates. However, on a cap-weighted basis, the revisions figure is strongly positive. This means that a few mega-cap names in the industry have strong revisions, while the majority of mid- and smaller-cap names have relatively weak revisions.

A similar but less dramatic picture is seen in IT Services, where revisions are much lower than in the hardware related industries on both equal-weighted and cap-weighted metrics. The cap-weighted figure is still higher than the equal-weighted, as it is for all Tech industries, but by a much smaller margin than in Software.

The overall picture from the bottom-up, stock level analyst revisions data is that hardware makers continue to surprise analysts positively across large and smaller companies alike, while providers of software and tech-related services are much more mixed and dominated by the largest names in those areas.

The second chart below provides some macro, top-down context for the bottom-up fundamentals we see. The top section of the chart plots the year-on-year percent changes in aggregate spending on investment in computer hardware (blue line) and in software (red line) over the last 30 years. The data come from the quarterly GDP data produced by the US Bureau of Economic Analysis. As of the end of 2020, the growth rate of investment in computer hardware had jumped to 16%, the highest reading since the previous recessionary rebound in 2009-10. Growth in software investment spending, by contrast, had only grown 5%, which is near the lower end of its recent historical range.

Source: Mill Street Research, Bureau of Economic Analysis

The bottom section of the chart plots the ratio of software to hardware spending over time. We see that the line has tended to rise, indicating higher growth in software spending than hardware spending on average over the long run. But the latest readings show a drop, reflecting the jump back toward hardware spending that occurred last year and likely is still ongoing. In the longer-term, it seems likely that software spending will again resume its higher growth rate versus hardware, but the preference for hardware is still very visible in current analyst earnings forecast behavior and could last a while longer as the world continues to adapt to the post-COVID landscape.

Semis vs Software trade now favors Semis

Within the broad Technology sector, there are often significant divergences among the various industries. A key intra-sector industry relationship that many investors use as a touchstone is the relative performance of Semiconductors versus Software.

These two industries capture different parts of the Technology ecosystem. Due to their widespread use in so many devices and products, the Semiconductors and Semiconductor Equipment industry reflects demand for hardware, both within Technology (servers, PCs, phones) and in other sectors (e.g. autos), and thus tends to be much more cyclical. Software tends to be much more stable, with more recurring revenue, and nowadays is closer to a service-type industry. There is much less chance of major “shortages” or “oversupply” of software of the kind that semiconductor makers must often deal with.

So even though software and semiconductors are complementary products (each requires the other), it is not hard to see that they can often have significantly different fundamentals and relative returns on an intermediate-term basis.

Our indicators currently show a growing shift in favor of Semiconductors over Software, both in fundamental earnings trends and relative returns. This is a reversal of the trend seen in the 2017-2019 period, when Semis lagged Software, and much of 2020 when relative performance was mixed.

The chart below shows the strong relationship between relative earnings estimate revisions activity in the two industries and their relative returns. The data are drawn from our broad US stock universe of about 2300 stocks (roughly, all US stocks with at least $200 million market cap and three analysts reporting estimates), and the constituents of each industry are equal-weighted in both the revisions and return series. The return series uses a five-day moving average to show the trends more clearly. Earnings estimate revisions breadth measures the average net proportion of analysts raising versus lowering estimates for each stock. Readings above zero mean more analysts raising estimates than lowering them on average.

US Semiconductors vs Software Revisions and Returns

We see that Semiconductor revisions breadth began losing its relative strength versus Software back in 2017, and continued through early 2019. At that point, Semiconductor revisions started to recover while Software continued a slow deterioration, allowing the relative revisions spread (middle section) to turn up from very negative (i.e., pro-Software) readings. That spread turned positive (favoring Semiconductors) in early 2020, just before COVID-19 hit, and then weakened again as many industries weakened simultaneously in the spring.  Both industries then had a simultaneous sharp rebound, along with most of the rest of the market, through the fall.

The last few months are where we again see a distinct divergence. Software revisions have clearly been losing momentum since September while those of Semis have held up and actually grown somewhat stronger. The spread is now quite wide and at multi-year highs in favor of Semis.

The bottom section of the chart shows the relative returns of the two industries, and we see the clear tendency for relative returns to follow the relative revisions. The relative return series has recently broken out of the range it inhabited for most of 2020, and looks set to follow the relative revisions higher. This suggests that Semiconductors should continue to outperform Software as long as the relative earnings indicators maintain their recent clear bias toward Semis.

Tech Sector In The Driver’s Seat For US Relative Performance

In this post, we highlight the interaction of US outperformance versus the rest of the world this year and US Technology relative to Ex-US Technology.

  • First, the relative performance of the US equity market versus the rest of the world has been highly correlated with the relative performance of US Technology stocks relative to Ex-US Technology stocks.
  • Second, the outperformance of US Technology, and by extension the major US indices versus their non-US counterparts, looks likely to continue based on relative earnings estimate revisions patterns.

The chart below supports our first point. The US has outperformed the rest of the world this year by a healthy margin, based on the MSCI regional benchmark indices, as shown in the top section (plotted using rolling five-day averages). The lower section isolates the Technology sectors for the US and the Ex-US universe (also using MSCI indices) and plots the relative return of the US versus Ex-US Technology sectors.

US vs Ex US and Technology Relative Returns

We can see the close parallels in the charts for the year-to-date: as US Tech outperforms Ex-US Tech, so does the broader US market outperform the Ex-US aggregate. This in some ways seems unsurprising given the heavy weight that the Tech sector holds in the US compared to many non-US markets, but the relative weights are unrelated to the relative performance of the US versus Ex-US Tech sectors. We find that even after removing the effects of sector weightings, US stocks have outperformed Ex-US stocks this year, and this effect is particularly strong within the Technology sector.

Our second point is captured in the chart below. It shows our measure of aggregated earnings estimate revisions (the percentage of analysts raising versus lowering earnings estimates) for the US Tech sector and the entire Global Tech sector (which includes the US).

Technology Sector Revisions Breadth Metrics

We can see here that earlier this year, US and Global Technology estimate revisions (fundamental trends) were mostly moving closely together and slightly favored non-US Tech (US Tech revisions were slightly weaker than Global Tech revisions).  Both revision metrics improved sharply from the April lows through today. But the difference between the US and the Global Technology sector earnings estimate measures moved dramatically in favor of the US in July after Q2 earnings reports came out, and have generally remained there ever since. This suggests that US Technology stocks have a strong fundamental tailwind relative to Tech stocks outside the US right now. If that US Technology tailwind persists, the broader US market seems likely to resume outperforming the rest of the world in the coming months.

Growth leadership easing as rotation increases

One of the most notable market trends in recent weeks has been the corrective action in the formerly high-flying US large-cap Growth stocks. The dominant Tech-oriented companies that have been responsible for much of the gains in US large-cap indices for several months finally saw some significant selling pressure in the first two weeks of September.

The first chart below shows absolute and relative returns for the S&P 500 Pure Growth and Pure Value indices (i.e., the style indices restricted to stocks that fall entirely into their indicated style, leaving out those with weight in both indices).

SP500 Pure Growth Value Indices

Key points:

  • The Growth index has been above its 50-day moving average since mid-April (and made new highs recently), but has now returned to that average after its recent correction. Any further declines could raise worries about an intermediate trend change.
  • The Value index has failed to even approach its January highs and has made little net progress since early June. It is also sitting near its 50-day average.
  • Growth/Value relative returns show little net change in the last two months, following a period of drastic Growth outperformance. This is consistent with our recent sector allocation recommendations to clients that have reduced style-level sector bets in favor of intra-style differences.

Corroborating the Growth/Value trends is the relative performance of the Growth-heavy Technology sector’s returns. Below is a chart showing our broad (300+ constituents), equal-weighted US Technology sector performance relative to the broad (2000+ constituents) US aggregate.  


We can see that after a period of sustained outperformance through the middle of this year, the relative returns for Tech have been much more mixed, and have dipped lately. Investor optimism toward Technology has shown signs of reaching extremes recently, and thus some corrective action is not surprising.

We continue to expect Technology to be a leading sector on an intermediate-term time frame, but both the sector and the overall market may have to go through further choppy trading activity and rotation near-term.

Global Technology: still outperforming, but is it expensive?

Much of the attention in equity markets has been focused on the Technology sector, many of whose constituents are reporting Q2 earnings now. The Technology sector has outperformed dramatically both in the US and globally in recent years as well as for the year-to-date. This has raised questions about whether the sector is “overowned” and overvalued, particularly given its unusually high weighting in the S&P 500 index now.

While it may seem almost a foregone conclusion that after extraordinary outperformance the sector must be overvalued, our data suggest this is not necessarily the case.  We review a couple of interesting charts below, focusing on relative returns and valuations (not absolute valuations).

Global Technology Relative Return

  • Tech stocks have indeed outperformed globally, extending a long-term trend in place for seven years and counting now. The chart above shows the relative return of global Technology stocks in our stock universe relative to the return of the entire global universe (~6000 stocks currently). The returns are calculated on an equal-weighted basis (to avoid the potential distortions of a few mega-cap stocks), though the trends using cap-weighted returns look similar.

Global Technology Relative Valuation

  • Based on the relative forward earnings yields1 in Technology versus the global average, the typical Tech stock is not currently very far out of line with historical norms on a relative basis in our work. And Tech stocks are actually cheaper on a relative basis now than they were at the start of the year.
  • The chart above shows the relative forward earnings yield for the median2 stock in the global Tech sector relative to the median stock in the global universe. The solid horizontal line is the long-run average, and the dashed lines are +/- 1 standard deviation from the average.
  • The current reading of -1.4% reflects the Tech sector’s current median forward earnings yield of 3.5% (equal to a forward P/E of 28.5) being 1.4% lower than the global median forward earnings yield of 4.9% (equal to a forward P/E of 20.4).
  • Technology is a growth sector, so it almost always trades at a lower forward earnings yield (higher P/E) than the overall market. Historically, the earnings yield differential has averaged about -1.2%, so the current valuation spread (-1.4%) is actually quite close to the long-run average.
  • Even though Technology has outperformed this year, the sector’s relative valuation has actually improved since the start of the year (from -1.6% to -1.4%). This is because expected earnings for Technology have also outperformed the global average by a substantial margin this year.
  • Confirming the global figures, the chart below shows the same calculation for the US Technology sector, where it may come as a surprise to some to see that the median US Technology stock is actually slightly cheaper than average on a relative basis now, and significantly cheaper than at the start of this year.

US Technology Relative Valuation

Using valuation alone as a timing tool can be quite challenging, but our data suggest that Tech stocks are not especially overvalued on a relative basis (i.e., putting aside whether the entire equity market is fairly valued or not on an absolute basis). So long as earnings in Technology continue to outpace the average, valuation does not appear to be a major headwind to the sector’s relative performance at this point, either globally or in the US.

1 We use earnings yields (earnings/price ratios) instead of price/earnings ratios in aggregate calculations to properly account for the presence of companies with negative earnings. Consequently, higher numbers are more favorable. The forward earnings are based on rolling 12-month forward consensus estimates.

2 Using the median stock avoids potential distortions that can occur in cap-weighted calculations, where unusual movements in a few mega-cap components can skew the sector’s valuation figures at times.