Buy These Stocks Because the Tech Rally Can Continue to Run, Analyst Says - Barron's

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The rally in technology shares rolls on.

Tech stocks appreciated about 50% in 2019, and have gained another 9% or so already in 2020. So what happens from here?

Goldman Sachs strategist Ryan Hammond looked at that and other questions about the tech rally in a research note Friday morning—and comes away still bullish on the sector. But he’s picky: Buy software over hardware, he writes, and large-caps over small.

Here’s a rundown on his top 10 questions—and answers—on the continuing run in tech shares. Note that for the purposes of this analysis, Goldman included traditional “info tech” stocks and leaves out the Internet sector.

How does the rally compare historically? It still pales compared with the Internet bubble. During the past five years, tech stocks have rallied 149%, versus 74% for the S&P 500. From 1995 to 1999, tech stocks soared nearly 700%, versus 250% for the S&P.

Hasn’t the rally been concentrated in just a few stocks? True, the five largest stocks are 18% of the current S&P 500 market cap, the highest concentration ever outside the bubble years. He says that over the last three months, the top five account for 12% of the sector’s overall returns, above average, but not as concentrated as 1991, 1996, 2001 or 2012. He notes that the average tech stock is within 4% of its 52-week high.

Do you still recommend over-weighting tech? Yep. He notes that the sector trades at a 22% valuation premium to the S&P 500—below the long term average of 31%. “When growth expectations are incorporated, Info Tech relative valuation appears even more attractive; the price-to-earnings ratio to growth ratio for the sector matches the S&P 500,” he writes. And he notes that the sector offers faster revenue and earnings per share growth and higher margins than the broad market.

What about coronavirus? “Our economists estimate that the coronavirus could shave nearly two [percentage points] off of global GDP growth in Q1, before eventually recouping most of that loss in later quarters,” he writes. “During previous China-focused shocks to global growth (e.g., trade war escalations in May 2019 and August 2019), Info Tech lagged the S&P 500. However, our Info Tech recommendation is for medium-term outperformance and based on structural trends, rather than tactical upside.”

Which industry groups do you like within tech? They recommend a tilt toward software. “Software and services fares best during periods of modest economic activity, as investors assign a premium to idiosyncratic growth profiles,” he writes. “The industry group also outperforms during periods of low interest rates, as the long-duration nature of growth stock cash flows increase in value when the discount rate falls.”

What’s the outlook for semis and hardware? “Although the semi cycle and economic activity appear to have troughed, prices have largely reflected these improvements,” the analyst writes. Goldman sees “moderate positive returns for the industry group, compared with the strong 43% return experienced during the past 12 months.”

Aren’t software and services stocks expensive? “While Software and services trades at a higher valuation relative to the broad index, its elevated profitability and growth supports these multiples,” he writes, adding that the sector tends to have momentum. Historically, he finds, “periods of Software and services outperformance have been followed by further outperformance over 6- and 12-month horizons.”

Portfolio managers are underweight tech. Is that a risk to the sector? “Hedge funds and mutual funds are both underweight Info Tech in aggregate,” Hammond writes. “Fund ownership does not necessarily suggest weak forward returns. However, several Info Tech names are very popular among fund managers,” the analyst writes, pointing to Apple (ticker: AAPL), Visa (V), Mastercard (MA), Salesforce.com (CRM), Adobe (ADBE), and PayPal (PYPL).” He adds that “tactically, the most popular stocks tend to lag during risk-off events, in part due to the higher liquidity of large cap names.”

Within software, do you prefer large-caps or small-caps? Buy large-caps, Goldman says. “Within the Russell 3000, the median software stock trades at an 182% [enterprise value]/sales premium to the index, the largest since the tech bubble, and 38 software stocks trade at more than 10x enterprise value/sales,” he writes “We previously found that stocks that trade at over 10x enterprise value/sales are usually unable to grow into their multiples, regardless of realized growth.”

What stocks screen as attractive within Info Tech? He offers a list of names with high and stable sales growth, high return on equity, and trading at a reasonable valuation. In software and services, the list includes Adobe, Dropbox (DBX), Mastercard, Genpact (G), Booz Allen (BAH), Visa (V), Paychex (PAYX), Microsoft (MSFT) and Intuit (INTU). In semis and equipment, their picks are Monolithic Power Systems (MPWR), Qualcomm (QCOM), Advanced Micro Devices (AMD), Teradyne (TER), Maxim Integrated Products (MXIM), Lam Research (LRCX) and KLA (KLAC). Their one tech hardware pick: Ubiquiti (UI).