XSW - IGV: Did OPEC+ Just Kill The Tech Rally?

2023-04-03 18:13:16 ET

Summary

• As most of you know, the technology sector was far-n-away the big winner in Q1 - confounding many of the tech naysayers and market prognosticators who were promoting energy.
• However, it would appear that OPEC+ has come to the rescue of the energy sector: Increasing its previous production cuts by an addition 1.16 million bpd.
• The cut, of course, is bad news for consumers, bad news for inflation, and bad news in terms of future interest rate hikes by the U.S. Federal Reserve.
• And bad news for the tech sector, right? Maybe so. Let's take a closer look.

During the first quarter of 2023, the tech sector shocked many investors and market pundits by significantly outperforming both the energy sector as well as the S&P 500 (see graphic below). However, this weekend OPEC+ surprised the market by announcing a furtherance of its previous production cut. In my opinion, it wasn't so much that OPEC+ cut production, but the size of the cut was significant and likely larger than many market watchers suspected: 1.16 million bpd . I was thinking there might be a cut - primarily because back in February Russia announced it was cutting its oil production by 500,000 bpd due to sanctions placed on it by the U.S. and its democratic and NATO allies. Over the long term, I suspect Russian oil productive capacity will keep falling off because most all of the western O&G producer and services companies previously operating in the country have fled due to Putin's war-on-Ukraine. Given that background, are higher oil prices going to take-down the technology sector like they arguably did last year? Let's take a closer look.

Investment Thesis

As you can see in the graphic above, the SPDR Tech Sector ETF ( XLK ) and the iShares Expanded Tech-Software ETF ( IGV ) vastly outperformed the Energy Sector - as represented by the SPDR Energy ETF ( XLE ) and Exxon Mobil ( XOM ) - as well as the broad market as represented by the Vanguard S&P 500 ETF ( VOO ). For more, see IGM: Surprise! The Tech Sector Is Outperforming And Cash Rich .

In my opinion, most of that out-performance was due to two primary factors, both of which worked to tamp-down inflation fears and therefore the rationale for more interest rate hike related pain:

1. Falling Oil Prices
2. The Silicon Valley Bank Failure

The chart above shows that tech stocks already had been outperforming as the price of oil (WTI - the purple line) weakened. However, the failure of SVB really turbo-charged the divergence given fears that getting business and consumer loans would get much harder and do some of the Fed's work for it. However, today - as a result of the OPEC+ announcement mentioned earlier - WTI is currently +$4.42/bbl (5.8%) and has broken-out strongly above the $75 range and - perhaps - bucking the downward trend put in place after the coordinated Strategic Petroleum Reserve ("SPR") releases last year (see graphic below). For more on that subject, consider reading Analysis: The Strategic Petroleum Reserve .

With that as background, let's take a look at the iShares Tech-Software ETF to see how it has positioned investors and whether or not high oil prices are likely to push shares back down.

Top-10 Holdings

The top-10 holdings in the IGV ETF (as of March 31) are shown below and were taken directly from the iShares IGV ETF webpage , where you can find more detailed information on the fund and its other holdings.

Not surprisingly, Microsoft ( MSFT ) is the #1 holding with an 8.9% weight. As I mentioned in my previously reference article on the IGM ETF, Microsoft ended its Q2 FY23 (calendar Q4) with $99.5 billion in cash and cash equivalents. That works out to an estimated $13.32/share based on 7.47 billion shares outstanding. During the latest quarter, Microsoft Cloud revenue continued to grow at a relatively rapid pace (+22% yoy and +26% on a constant currency basis). Microsoft also has two additional catalysts going for it: Its investment in Open AI and positive regulatory news on the company's effort to acquire Activision Blizzard ( ATVI ). As a result, it now looks more likely than not that the acquisition will be allowed to move forward (ATVI stock was up strongly the day of the regulatory news).

Salesforce.com ( CRM ) is the #3 holding with an 8.73% weight. Interestingly enough, Salesforce was the stock that replaced ExxonMobil in the DJIA back in August 2020. Let's take a look at the performance of both stocks since that relatively titanic shift in the DJIA composition:

As you can see, the change didn't work out well for holders of the DJIA ETF ( DIA ). Regardless, Salesforce has been making strong progress at addressing the major criticisms of activist investor Elliot Management : Growing profits while expanding its scalable SaaS-based platform, becoming more efficient, and increasing shareholder returns. Indeed, on March 1 CRM reported Q4 earnings which were a top and bottom line beat . In addition, FY2024 Non-GAAP EPS guidance of $7.12 - $7.14 was significantly above consensus ( $5.87 ) while yoy operating cash flow was expected to grow 15%-16%.

CRM announced it was expanding its share buyback program to $20 billion. During FY23, Salesforce bought back $4 billion in stock ($2.3 billion in Q4).

The #5 holding with a 6.6% weight is Intuit ( INTU ). INTU provides well-know financial management and tax-tools like QuickBooks and TurboTax, respectively. Intuit has a solid revenue growth track-record and is expected to continue that going forward while earning an estimated $8.48/share this year:

My favorite cyber-security company, Palo Alto Networks ( PANW ), is the #8 holding with a 3.2% weight. PANW stock is down 6.2% over the past year, even as the stock surged after a strong Q2 EPS report that blew past estimates. Palo Alto earned $1.05 per share on $1.7 billion in revenue. Analysts were expecting EPS of 78 cents on $1.65 billion in revenue. The company said billings rose 26% yoy to $2.03 billion during the period.

As analyst Dan Ives put it:

Taking a step back, the cloud transformation at (Palo Alto) is well underway and the company is becoming the Aaron Judge of cyber security as larger more strategic deals are getting inked despite the 'best days are in the rear view mirror' Street naysayer crowd.

Following the results, Ives boosted his per-share price target on PANW from $200 to $210. At pixel-time, PANW stock is trading at $196.45.

The top-10 holdings are rounded out by a pair of companies that dominate CAD software for semiconductor design engineers - and have since I began my career as a design engineer in the early 1980s: Synopsys ( SNPS ) and Cadence ( CDNS ). Combined, the two have an aggregate 6.1% weight in the IGV portfolio. These two companies are a relatively entrenched duopoly at technology companies around the world and can pretty much be considered to operate SaaS-based business models with significant ARR (annual recurring revenue). SNPS stock is +14.4% over the past year while Cadence is +25.2%. Cadence delivered a very strong Q4 earnings report as well as forward guidance that was significantly ahead of consensus estimates. Cadence ended FY2022 with $1.1 billion in cash and cash equivalents.

Performance

As of the end-of-year 2022, and despite the last year's tech bear market, IGV has a very strong 10-year average annual return of 15.3%:

The graphic below compares IGV's five-year total returns to those of competitors like the XLK ETF, the Nasdaq-100 Trust ( QQQ ), the Invesco Dynamic Software ETF ( PSJ ) and the SPDR S&P Software & Services ETF ( XSW ):

Other than the last two ETFs (PSJ & XSW), these picks have significantly outperformed the broad market over the past five years (the VOO has returned 70% over that time-frame), albeit both the SLK and QQQ ETFs have significantly outperformed the IGV ETF.

Risks

Getting back to the oil discussion I touched on earlier, the high-price of oil combined with the U.S. interest rate increases were primarily what drove the value of the U.S. dollar higher last year:

But that trend obviously broke last November. However, what's interesting to me is that the U.S. dollar opened up much higher this morning (after digesting the OPEC+ news), but at pixel time is now down 0.43% for the day (see graphic above).

As you know, a strong U.S. dollar is an FX headwind to many of the software companies held in the IGV ETF portfolio considering that most operate global platforms. That being the case, revenue from foreign operations have to be translated back into U.S. dollars - and the higher the value of the U.S. dollar, the less those foreign revenue sources are worth. Indeed, one only has to consider the Microsoft Cloud revenue referenced earlier:

+22% yoy and +26% on a constant currency basis

In other words, the strong U.S. dollar effectively cut 4 percentage points off of MSFT's reported Cloud revenue - arguably clipping the wings of a primary growth catalyst for the company. The key point here is that investors in the software sector (and tech sector in general) should keep a keen eye on the value of the U.S. dollar. My personal view is that the outlook for additional Fed rate hikes has diminished somewhat given the impact of the SVB failure. I also hold the view that OPEC+ and the powers-that-be in the oil market understand that super high oil (i.e. gasoline) prices will likely and significantly accelerate the transition to EVs, which would undermine the long-term value of their resource base over time.

IGV's expense fee of 0.40% is high and a full 30 basis points higher than the XLK ETF (0.10%). Over the long-term, that is a drag on performance.

Despite the 2022 bear-market, the IGV ETF is still quite richly valued as compared to the S&P500 (in parenthesis):

• Price-to-book = 6.7x ( 4.1x )
• P/E = 50.3x ( 22.1x )

That being the case, the IGV is exposed to valuation contraction should a stronger dollar and/or higher interest rates exert themselves.

Summary and Conclusion

On the first full day of trading post the OPEC+ decision to cut production, the IGV ETF closed down 0.73%. That seems rational to me. Given we're now in oil's "shoulder season" (i.e. between winter and summer driving), and OPEC+ is cutting production prior to the summer driving season, I do think oil is going to continue trading higher. That said, I doubt seriously that Brent will come near to the $120/bbl level it hit after Russia invaded Ukraine last year. I'd argue that Russia effectively broke the global energy supply chain last year (and the food supply chain as well), but that over the past year, the global energy supply chain has already been successfully changed forever. I think the sweet-spot for oil is in the $85-$90/bbl range, which delivers strong free cash flow for the oil producers and petro -states, yet doesn't totally cripple the global economy and/or force consumers - many of whom otherwise wouldn't - to consider buying an EV.

That being the case, the big software companies in the IGV ETF - most all of which are quite profitable, cash rich, and demonstrated solid (if not excellent) growth last year - will continue to thrive. However, over the near term the IGV ETF could trend lower. I would try to take advantage of market volatility to buy shares aggressively if they came anywhere new the lows of last year again (~$250). Otherwise, I rate IGV a HOLD here.

I'll end with a 10-year chart comparing the returns of the IGV ETF, the S&P500, and Exxon:

Note that IGV has significantly outperformed both the S&P 500 and Exxon over the past decade. That being the case, I argue that the narrative some analysts are spinning (it's either tech or energy) is false, because in my opinion - for the well-diversified investor who stays in the market through its up-n-down cycles - it simply is not a question of either/or, it's "both."

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