DDOG - IGM: Surprise! The Tech Sector Is Outperforming And Cash-Rich

2023-03-24 23:14:35 ET

Summary

• Higher interest rates and worries about banking system stability and a recession have rocked the market and caused the energy and financial Sectors to sell off.
• Surprisingly enough to some investors, the technology sector has been the outperformer year-to-date. I'll explain below why investors can "bank on tech" going forward.
• Investors who may be light on tech stocks, and who want to build a more durable and well-diversified portfolio, should consider the iShares Expanded Tech Sector ETF.
• The IGM ETF is up 17%-plus YTD, has a 0.40% expense fee, and its top 5 holdings are Google, Microsoft, Apple, Amazon, and Nvidia.

As you know, the energy and financial sectors have been beaten down this year due to higher interest rates, concerns about a potentially "hard-landing" and recession, and worries about the integrity of the banking system. Getting much less attention is the fact that big tech has rallied sharply this year (see chart below). That's because these big tech companies are cash rich, don't need to borrow money at any interest, and are still generating strong free cash flow. As a result, investors who find themselves under-allocated in the technology sector should consider buying a well diversified fund like the iShares Expanded Technology ETF ( IGM ).

As the graphic above demonstrates, the IGM ETF has not only out-performed the broad market averages like the S&P 500 and DJIA, as represented by the Vanguard S&P500 ETF ( VOO ) and SPDR DJIA ETF ( DIA ), respectively, but it has absolutely clobbered the SPDR Energy Select ETF ( XLE ) and SPDR Financials ETF ( XLF ) year-to-date . In addition, IGM has outperformed the Nasdaq-100 Trust ( QQQ ) this year by almost 0.9%.

That might surprise some investors who followed the general narrative that technology stocks would remain under pressure so long as interest rates are rising. However, while that narrative was certainly true during the 2022 bear market, it has fallen apart this year. As the chart below shows, that's likely because the Federal Reserve has decelerated its rate increases from 0.75%, to 0.50%, and this year - to two successive 0.25% increases:

Now, inflation is still much higher than the Fed's 2% target. However, given recent instability in corners of the banking sector, and the perception that instability will result in a tightening of credit and will be an additional damper on the economy, the general consensus is that the Fed is close to the end of this tightening cycle. Indeed, at pixel time the current 1-year Treasury rate is only 4.3% which is obviously less than the current 5% Fed Funds rate. That is, the interest rate curve is steeply inverted in the short term and investors are expecting interest rate cuts over the next 12 months. If so, that would be a boon for technology investors.

Indeed, after rising during the month of February and the first couple of weeks in March, the U.S. dollar index has recently turned lower (excepting today, Friday, March 24):

That too is good for technology stocks because most of them have global brands and a strong U.S. dollar is a foreign currency headwind to their U.S. dollar-denominated earnings.

With that as a backdrop, let's take a look at how the IGM ETF has positioned investors for success going forward.

Top 10 Holdings

The top 10 holdings in the iShares Expanded Tech Sector ETF are shown below and were taken directly from the IGM ETF webpage where you can find more detailed information on the fund:

If we count both A and C classes of Google stock, in aggregate parent company Alphabet ( GOOG ) (GOOGL) is the No. 1 holding in the IGM ETF with a 9.2% weight. As my faithful followers know, Google continues to be my favorite mega-tech company due to its strong free cash flow profile, its excellent global position and branding in search and video, and for its vastly under-valued "other" categories like AI and autonomous driving.

Google is sitting on a ton of cash: It ended Q4 FY22 with $139.6 billion in cash and cash equivalents (an estimated $10.37/share). During the quarter, Google Cloud ("GCP") revenue grew 32% yoy to $7.3 billion. Google generated $16 billion of FCF during the quarter - which was 21% of total Q4 revenue.

When I say investors can "bank on tech," consider that Google's cash position is larger than the entire market caps of financial companies Morgan Stanley ( MS ), Wells Fargo ( WFC ), and Goldman Sachs ( GS ) - which are $144 billion, $138 billion, and $111 billion, respectively. In addition, and what probably came as a shock to many energy investors who thought tech was dead last year, Google actually generated more FCF than Exxon ( XOM ) in Q4 (see: Q4 Surprise: Google Generated $3.8 Billion More Free Cash Flow Than Exxon ). That is, even in an energy "up-cycle" and a tech "down-cycle," Google continued to generate much more FCF than is Exxon.

The #2 holding is Microsoft ( MSFT ) with an 8.9% weight. Microsoft ended its Q2 FY23 (calendar Q4) with $99.5 billion in cash and cash equivalents - or an estimated $13.32/share based on 7.47 billion shares outstanding. During the quarter, Microsoft Cloud revenue gained 22% yoy (26% on a constant currency basis). In addition to its cloud business, Microsoft has two additional catalysts going for it: Its investment in Open AI and positive news today on the regulatory front with respect to the company's effort to acquire Activision Blizzard ( ATVI ). ATVI stock jumped 5.9% today as it now looks more likely that the acquisition will be allowed to proceed.

Apple (AAPL) is the #3 holding with an 8.5% weight. Apple is another cash-rich tech stock that ended Q1 FY23 with $30 billion in cash - and that was after returning $25 billion to shareholders via dividend payments and share buybacks during the quarter. While Apple is arguably facing some supply-chain challenges to reduce its dependence on Chinese manufacturing, the stock is up 28% YTD in what some would argue (and I'm arguing) is a flight to quality.

The IGM ETF has allocated 6% of the portfolio to two credit card processing companies: Visa ( V ) and Mastercard ( MA ). Today, Visa increased its offer to buy Fintech company Pismo for $1.4 billion . Pismo is a Brazilian company that's backed by Amazon ( AMZN ) and SoftBank and operates a cloud-based banking and payments platform for banks. Mastercard also has been busy in M&A. MA recently acquiring Baffin Bay - a cloud-based cybersecurity company - in order to add automated threat protection services to its cyber security offerings in order to enable businesses to ward off cyber attacks.

The top-10 holdings are rounded out by Broadcom ( AVGO ) with a 2.4% weight. As I wrote in a recent Seeking Alpha article on Datadog ( DDOG ), Broadcom will be A Sure-Fire Winner In The AI Arms Race . That's because AVGO arguably operates the best networking development platform (both hardware and software) on the planet and is always at least one step (if not two) ahead of the competition.

Hyperscalers like Microsoft, Google, and Amazon that are focused on regenerative AI will need to feed massive amounts of mega data, typically residing in the cloud, to keep high-performance computing ("HPC") engines running their AI and ML algorithms. That requires high-speed networking and Broadcom has the best line-up in the business - from switches to optical interconnect:

Indeed, on the Q1 FY23 conference call earlier this month, and speaking of the hyperscalers, CEO Hock Tan said:

Such networks have to be lossless, low latency and be able to scale. So as you know, such AI networks are already been deployed at certain hyperscalers through our Jericho 2 switches and Ramon Fabric. In fact, in 2022, we estimated our Ethernet switch shipments deployed in AI was over $200 million .

With the expected exponential demand from our hyperscale customers, we forecast that this could grow to well over $800 million in 2023. We anticipate this trend will continue to accelerate and mindful that we need even more higher performance networks in the future .

In other words, Broadcom's Ethernet switching business is expected to grow by 4x yoy, with a strong AI tailwind moving forward.

Meantime, Broadcom's Q1 EPS report was another strong top- and bottom-line beat . Revenue of $8.92 billion was +15.7% yoy and Kirsten Spears , CFO of Broadcom Inc., said: " We generated $3.9 billion in free cash flow, representing a 16% increase year-over-year, and expect even stronger free cash flow in the second quarter. " Note that Broadcom's Q1 FCF was 43.7% of total revenue, that's more than double Google's free-cash-flow margin (see above).

Broadcom pays a $18.40/share annual dividend, currently yields 2.88%, and trades with a forward P/E of only 15.5x. At the current price of $636, AVGO stock is a steal here and you can see why it is my favorite all-weather semiconductor company.

For the portfolio as a whole, it's most highly exposed to the semiconductor sub-sector while the "Other" category must include "Financial" companies like Visa and Mastercard (which are really FinTech companies in my opinion):

Performance

As of year-end 2022, and despite being down a whopping 35.9% last year, the IGM ETF still has a very strong 10-year average annual return of 16%:

I would argue that last year's sell-off was overdone and is one reason IGM is +17.3% YTD.

The following graphic compares the five-year total returns of the IGM ETF against some of its peers like the triple-Qs, the iShares Expanded Tech & Software ETF ( IGV ), and the SPDR Select Technology ETF ( XLK ):

As you can see, both the XLK and QQQ ETFs have out-performed the IGM ETF, which in turn has outperformed the IGV ETF by 15% and the S&P500 - as represented by the VOO ETF - by 22.4%.

Risks

As you can see from the IGM ETF valuation metrics below (underlined in red), and despite the big sell-off last year, this is still a highly-valued fund that trades at a significant premium to the market:

However, I would argue that the premium is warranted given the large cash positions many of these companies have, their strong free cash flow generation profile, and the fact that the fundamental drivers - the cloud, AI, and high-speed networking, just to name a few - will continue for many years to come. Indeed, just today Seeking Alpha reported that Ann Winblad, co-founder and managing partner of Hummer Winblad Venture Partners, thinks that "AI will likely fuel the next stage of innovation." Winblad called out names like Microsoft, Google, Nvidia, Apple, and Amazon among the potential winners. Note those are the top-5 holdings in the IGM ETF.

The downside risks are that inflation stays stubbornly high and the Fed has to keep hiking interest rates. That would lead to a strong U.S. dollar and a big foreign currency headwind for big Tech. On the other hand, these companies are earning much higher returns on their cash positions.

Summary and Conclusion

Investors who sold out of the technology sector after the bear market last year are likely kicking themselves for doing so (especially if they moved the proceeds into the Energy or Financial Sectors). My strategy is to build - and hold - a well-diversified portfolio through the market's up-n-down cycles because it's extraordinarily hard for professional money managers (let alone ordinary investors) to predict what the market will do and/or "time" the various sector rotations. For instance, many investors know that a rising interest rate environment is supposed to be bad for technology and great for banks because their net-interest margin ("NIM") grows and that leads to bigger profits for the banks. Well, surprise - the Technology Sector has whooped the Financials so far this year, and I expect that to continue through the rest of this year and for many years to come.

For further details see: