TXN - FTEC: Fidelity's Tech ETF Is Solid And Defensively Positioned

Summary

• FTEC is a five-star rated technology ETF with a strong performance track record: The average annual return over the life of the fund is 16.82%.
• However, with 38.5% of the fund allocated to only two stocks (Apple and Microsoft), FTEC is arguably positioned rather defensively.
• Yet that might be just the right move given current economic cross-currents, a rising interest rate environment, and still skittish investors who just suffered through a bear market.
• Today, I'll give an update on the FTEC ETF (expense ratio 0.08%) to see if it might be a nice addition to your well-diversified portfolio.

As mentioned in the bullets, the Fidelity MSCI Information Technology ETF ( FTEC ) has an excellent long-term performance track record and - with an expense ratio of only 0.08% - is quite affordable. Yet for those investors looking for out-sized rewards in the technology space, the FTEC ETF is probably not the best choice given the portfolio is highly weighted in only two big companies: Apple (20.4%) and Microsoft (18.1%). That said, given current global economic cross-currents (the Russia/Ukraine conflict, high inflation, a rising interest rate environment, etc.), such a defensive position might be exactly the right move. Today, I'll update investors on the FTEC ETF and see if now might be the time to initiate a position - or to add to an existing position - in the fund.

Investment Thesis

As you already know, the 2022 bear-market was especially hard on the technology sector. Yet - in my opinion - the long-term outlook for technology stocks is as bright as ever. Long-term demand from a plethora of tech sub-sectors (5G smartphone and infrastructure, high-speed networking, EVs, high-performance computing ("HPC"), AI & ML algos running on specialized and optimized hardware, wireless mobility, IoT, data centers, and clean-green technology - just to name a few) can only be satisfied by technology companies. There's no doubt in my mind: Technology will be the most important sector of the global economy throughout the 21st Century. That being the case, well diversified investors must have decent exposure to this sector.

Meantime, and despite the 2022 bear-market thrashing, it's important to understand that the technology sector - as represented by the Nasdaq-100 ETF ( QQQ ) - has significantly outperformed the broad market - as represented by the Vanguard S&P500 ( VOO ) and SPDR Dow Jones Industrials ( DIA ) ETFs - over the past five years:

That being the case, let's take a closer look at the FTEC ETF to see how it has positioned investors for success going forward.

Top-10 Holdings

The current top-10 holdings in the FTEC ETF are shown below and were taken directly from the Fidelity FTEC homepage where you can learn more detailed information on the fund. The top-10 holdings equate to ~59% of the entire 367 company portfolio and, as such, is what I consider to be relatively concentrated fund. That is, not very well diversified:

The #1 holding is Apple ( AAPL ) with a 20.4% weight. Due to the impact of COVID-19 and the recent China/U.S. technology trade spat, Apple's big exposure to China has become a front-n-center issue that requires big changes. While the Apple/China relationship has been a boon for both, Apple has no choice but to diversify its supply-chains away from China. Indeed, just today Bloomberg reported that Jabil ( JBL ), a leading Apple supplier, is now making AirPod components in India. Expect more of these type announcements going forward - including, eventually, that Apple is making high-end iPhones in a more geographically diversified footprint. This could negatively impact Apple's margins, but - in the long run - significantly increase the security of the company's supply-chain. Apple currently trades with a forward P/E of 23.8x.

Speaking of Jabil, the company is one of my top technology picks for 2023 because it's ideally positioned for the China off-shoring theme. See Jabil: On Fire YTD (+13%) And Still A Fantastic Value . Unfortunately, FTEC only has a 0.11% position in the company.

Microsoft ( MSFT ) is the #2 holding with an 18.1% weight. Microsoft has obviously seen a significant deceleration in commercial bookings:

However, remaining commercial performance obligations continued to grow in Q2 FY23, cloud revenue continues to grow, and cloud gross margins are still a very healthy 72% - which were actually up two percentage points yoy.

In Q2, Microsoft's FCF was $4.9 billion , down 43% yoy. However, if we exclude some one-time charges, FCF was down only 16%. During the quarter, MSFT continued to be a very shareholder friendly company - returning $9.7 billion to shareholders: $5.1 billion in dividends, and $4.6 billion in share buybacks.

Nvidia ( NVDA ) is the #3 holding with a 3.9% weight. Nvidia was a high-flyer going into the 2022 bear market and despite a an impressive 37% rally YTD, the stock is still down 10.4% over the past year. Nvidia's Q3 release in November was a bottom line miss, but revenue of $5.93 billion (-16.5% yoy) was actually a $110 million beat . Gross margin of 53.6% was down almost 12 percentage points from Q3 of last year.

Another one of my top technology picks for 2023, Broadcom ( AVGO ), is the #6 holding with a 2.4% weight. Broadcom, the leading high-speed networking company on the planet, started the year with its fab capacity fully sold out. That's at least the third year in a row that Broadcom has done that, and note that CEO Hock Tan is famous for having a "no cancellation" order policy. You order, you take delivery and pay - simple as that.

If you haven't already read my Seeking Alpha article from earlier this month, consider reading CEO Shakedown: Hock Tan vs Tim Cook . Broadcom also is a leading Apple supplier and sells the company a number of RF, WiFi/Bluetooth, and custom mixed signal solutions. The two CEOs - arguably two of the best in the business - have faced off in very interesting contract disputes in the past. Each have been positioning their company prior to negotiations because the last two-year contract is schedule to expire soon. This has been a fascinating high-stakes battle between the two, and I hope you have time to read the article.

It's a shame that the FTEC ETF tracks the MSCI Index and, as such, cannot hold a bigger allocation to Broadcom. Given the strength of its portfolio, its ability to generate strong FCF (a whopping $16.3 billion of FCF in FY22), and its strong dividend ($18.40/share annually, 3.1% yield), I cannot think of a better defensively-positioned technology company to hold in 2023 than Broadcom. That's because AVGO - perhaps unlike many technology companies - is sure to grow in 2023, just like it did last year.

With a 1.6% allocation, Texas Instruments ( TXN ) rounds out the top-10 holdings. Last week, TI delivered relatively strong Q4 results : GAAP EPS of $2.13 was a $0.15/share beat while revenue of $4.67 billion (-3.3% yoy) beat by $40 million. TXN yields 2.83% and trades with a forward P/E of 22.9x.

Performance

As of year-end 2022, and despite the bear-market mauling last year, the FTEC ETF has a very strong long-term performance track record:

(Note those end-of-year returns are significantly higher now given FTEC is up 9.7% YTD).

The following graphic compares FTEC's three-year total returns with that of some of its competitors: the Vanguard IT ETF ( VGT ), the SPDR Technology Select Sector ETF ( XLK ), the SPDR NYSE Technology ETF ( XNTK ), and the triple Qs:

As can be seen, the FTEC ETF has acquitted itself quite well, out-performing all but the XLK ETF - which bested it by 5.4%. XLK has a 0.10% expense fee, a couple basis points higher than FTEC's.

Risks

As mentioned previously, the tech sector is not immune to the challenges facing the global economy: The Russia/Ukraine conflict, high inflation, and a rising interest rate environment, just to name a few. However, one of the biggest headwinds that rocked the tech sector last year - the strength of the U.S. Dollar - has suddenly become a tailwind:

I say that because the U.S. dollar arguably peaked last September and - in my opinion - is likely headed back below 100 sooner rather than later. This is a boon for technology companies that generate a large percentage of sales overseas and have to convert earnings back into U.S. dollars. Looking at the chart, year-over-year comparisons will become much easier as we get into the second half of this year.

Meantime, for big cash-rich and free cash flow generating companies like Apple and Microsoft, rising interest rates aren't that big a threat to their balance sheets.

Summary and Conclusions

I like the FTEC ETF and - full disclosure - I own it. It's a very solid fund that sports a Morningstar 5-star rating. Yes, the fund is arguably over-weight Apple and Microsoft - so for those of you that already have large positions in either of those two companies, you're probably better off looking for a more well-diversified technology ETF.

However, I like the relatively defensive position of the fund and suggest it's nicely positioned for a rebound in the technology sector - which will, at some point, come full circle. Indeed, YTD we already have seen a glimmer of life in the tech sector.

FTEC is a BUY and should be considered as a core long-term technology holding for those investors who want to build and hold a well-diversified portfolio throughout the market's up-n-down cycles.

I'll end with a 10-year price chart of FTEC and note that investors have seen a better than 4x return over that time frame:

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