Invest in the Future of Innovation

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1 Schwab Center for Financial Research Invest in the Future of Innovation Brad Sorensen Managing Director of Market and Sector Analysis

2 We believe investors need to have a reasonable percentage of their equity assets allocated to technology, given that the United States remains an innovation powerhouse and that U.S. technology companies are playing an instrumental role in addressing a number of generational challenges. In a wide-ranging conversation, Brad Sorensen builds the case for investing in technology stocks now. Brad Sorensen, CFA Managing Director of Market and Sector Analysis, Schwab Center for Financial Research Brad Sorensen heads market and sector analysis for the Schwab Center for Financial Research and writes for several Schwab publications. He is a member of Schwab s Investment Strategy Council. This white paper is part of a continuing series of timely and actionable investing ideas provided by the experts at Schwab Center for Financial Research (SCFR). The guidance provided through these investing ideas will be updated over time as market conditions change and as SCFR s point of view evolves. 2

3 Executive Summary Judging by stock performance and anecdotal evidence, some investors are shunning technology stocks. A new surge in U.S. technology innovation appears to be occurring, so now is a good time for investors to add to their tech allocations. Companies have increased their cash balances in part by holding off on making capital expenditures needed to upgrade and improve current systems. With global economic forces appearing to be bottoming or turning upward, we expect companies to begin to catch up on tech spending. The tech sector appears attractively valued both by historical measures and relative to other industries, presenting an attractive entry point for long-term investors. Why technology stocks and why now? We believe the future of economic growth in the United States and beyond rests in a continued ability to innovate. In our view, technology rests at the center of this need, and the future looks bright. A number of recent technological innovations started to be recognized in 2013 and will continue to be through 2014 as investors are finally able to take some of their attention away from political issues. Encouraging signs of breakthroughs are evident in a range of areas, including energy, health care, consumer products, travel, manufacturing, and shipping. This indicates that game-changing advances are certainly possible and maybe even likely in the relatively near term. The tech sector appears attractively valued both by historical measures and relative to other industries, presenting a nice entry point for long-term investors. It is also clear to us that global competition is increasing, resulting in businesses putting more focus on containing costs. We believe technology will play a large part in that process as companies look to improve productivity and efficiency to help offset the increasing costs of health care and other services. 3

4 What does Schwab recommend? We believe that investors who have not brought their tech sector allocations up to market weight should do so immediately. Nearly all equity investors should have exposure to the sector, at least close to consistent with the chosen benchmark level. Investors who want to be more tactical in some of their investing decisions should add to their technology stock positions and establish a modest overweight position. With the market at record highs, aren t tech stock valuations too high? As with most products, buying stocks at a good price is important. At the same time, there can be relatively better times than others to add to certain positions. To us, now appears to be one of those times for technology stocks. As shown in this chart, tech sector valuations appear attractive based on historical levels. The tech sector s current price-to-earnings ratio has risen recently but still remains below the 15-year average of 23.1 times the projected performance over the next 12 months. 1 Valuations appear attractive based on historical levels 60 Information technology sector price-to-earnings ratio 50 Ratio Source: FactSet, Standard & Poor s as of December 10, Strategas Research Partners as of December 10,

5 What is holding investors back? Some investors may harbor memories of the tech bubble in the late 1990s. But the sector, in our view and by the measures discussed below, is currently in a much different state and in many ways doesn t resemble that of the bubble era. Global growth concerns also appear to be weighing on the sector, coupled with budgetary and regulatory uncertainty in the United States. Companies don t seem to be exploiting technology advances as quickly as they have in the past. Since the financial crisis in 2008, businesses have been hit with one confidence-crushing event after another, from the housing bust and Lehman Brothers failure to the European debt crisis, U.S. credit rating downgrade, and debt ceiling debate. These episodes seem to have exacerbated wariness among business leaders, prompting them to solidify their current standing as opposed to expanding and pushing into new areas for growth. That perceived lack of confidence could have kept some investors on the sidelines. How will companies find the confidence to invest in technology? By looking at their balance sheets, for starters. As you can see in the chart on the next page, cash balances were built steadily after the financial crisis and have continued to rise, with cash as a percentage of total assets also growing. Many companies are sitting on cash, and pent-up demand for technology investments is building. 5

6 We believe this cash buildup has come at the expense of capital expenditures needed to upgrade and improve current systems. People who don t consistently maintain and improve their homes have to play catch-up at some point, and it s the same with businesses. Pent-up demand for technology investments is building. As most investors know, cash is earning minuscule yields. Management and shareholders alike would certainly like their money to earn a better return than that provided by short-term fixed income securities. Therefore, our belief is that cash sitting in those kinds of instruments increasingly will be put to use investing in the potentially higher returns that come from the business itself such as capital expenditures to increase efficiency or boost production. There is plenty of fuel to pay for technology improvements 2,000 13% 1,850 Billions U.S. $ 1,700 1,550 1,400 12% 11% Percent of Assets 1,250 1,100 10% Cash as % of total assets nonfarm, nonfinancial corporations (right) Cash on balance sheet nonfarm, nonfinancial corporations (left) Cash includes check deposits and currency, commercial paper, foreign deposits, money market fund shares, mutual fund shares, time deposits and savings, and government agency and Treasury securities. Source: FactSet, Federal Reserve as of December 10,

7 Is there any evidence that businesses are beginning to put that cash to work? We ve started to see capital expenditures improve, as you can see in this chart. But after the sharp pullback we saw during the financial crisis, we believe there will be more catch-up spending in the coming months and years. There is still quite a bit of room to return to capital-expenditure trend levels 5,000 Capital expenditures for all U.S. sectors Billions U.S. $ 4,000 3,000 2,000 Jan Jan Jan Jan Jan Source: FactSet, Federal Reserve as of December 10, Jan Jan Jan Jan Jan Aren t there other things companies could do with the cash instead? Companies could choose to return the cash to shareholders in the form of share buybacks or increased dividends. But we believe there will be a mix of investing and returning cash, something we ve already begun to see. To the extent that companies choose to spend on tech innovation, it would represent an increase over the levels seen in recent years. To the extent that companies within the tech sector choose to boost dividend payments, a trend we ve seen over the past couple of years, it could open up the sector to a whole new class of investors. 7

8 What about the uncertain business environment? It s true that businesses were even more cautious in the fourth quarter of 2012 as they awaited the results of the election and the fiscal cliff negotiations. If you look at this chart, you can see that cautious stance bearing out in commercial and industrial lending activity. Flattening business lending is indicative of increased caution Commercial and industrial lending Year-Over-Year % Change Jan. 00 Jan. 02 Jan. 04 Jan. 06 Jan. 08 Jan. 10 Jan. 12 Jan. 14 Source: FactSet, Federal Reserve as of December 31, But in our view, the issues that have been causing businesses to be excessively cautious are either diminishing or resolving themselves. The fiscal cliff issues are being addressed perhaps not in the way that many people would have liked and fears of another government shutdown have been greatly reduced since the budget agreement. Given the uncertainty we have seen over the past couple of years, any meaningful improvement is likely to buoy business spirits. Won t the global economy especially China be a drag on technology growth? We believe the overall global environment is poised to contribute to the positive story for technology. Central banks are easing around the world, with only the U.S. Federal Reserve looking at pulling back to any degree among major central 8

9 banks. That should help stimulate growth. While the explosive growth story in China may be over, we also believe that the Chinese economy will benefit from structural changes currently being undertaken. The U.S. economy isn t the strongest either. Doesn t that reduce the chances of companies reinvesting? In the U.S., the ISM non-manufacturing survey, which tends to be a leading indicator of service sector activity, remains in positive territory. 3 The improving housing market and growth in auto sales over the course of the past year are also encouraging signs of increasing consumer confidence. While we don t believe that the U.S. economy will return to robust growth in the near future, growth does appear to be improving. At the very least, we believe the improved outlook will spur more businesses to spend on expansion. Are there any risks to your positive view of the tech sector? There are always risks. In this case, the biggest risk in our view is that global growth doesn t recover and we have another downturn. Europe remains slow, 4 and there is potential for other countries, including the United States, to downshift as they grapple with their fiscal situations. This situation would cause companies to curtail spending on technology and could dampen the performance of tech stocks. We could also see continued business uncertainty as a result of renewed political skirmishes in Washington, which could make it difficult for businesses to plan for the future since they won t know what potential tax and regulatory changes are coming. Should that uncertainty remain elevated, companies would likely continue to hold cash close and not spend it. We believe both risks are pretty unlikely, though. The U.S. economy appears to be gaining momentum, and other key countries appear to have stabilized. In the end, companies largely exist to make money, and in order to do that they have to invest in their businesses to keep pace with the market. We believe the overall global environment is poised to contribute to the positive story for technology. 3 as of December Eurostat report as of December 6,

10 Important Disclosures Past performance is no guarantee of future results. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here are obtained from what are considered reliable sources; however, accuracy, completeness, or reliability cannot be guaranteed Charles Schwab & Co., Inc. All rights reserved. Member SIPC. CS ( ) PLC (03/14)