A reader asked me to write about how I approach investing in tech stocks, an area I like and one which I think I’ve acquired some competence in over the years.

IT as a component of the S&P 500

Let’s start with the structure of the S&P 500, which, as of yesterday’s market close, looked like this:

Information Technology          22.5% of the index

Financials          14.1%

Healthcare          14.0%

Consumer discretionary          12.5%

Industrials          10.2%

Staples          9.3%

Energy          6.3%

Utilities          3.2%

Real estate          2.9%

Materials          2.9%

Telecom          2.3%.

Source:  Standard and Poors

Yes, the numbers add up to 100.2% but that’s just rounding and doesn’t affect analysis.

 

An obvious conclusion from this list is that when we buy an S&P index fund, almost a quarter of what we get is already tech.

A second observation is that 22.5% is a big number.  But if we look back to the end of 2009, when the current bull market was in its earliest stage, IT represented 19.8% of the index.  In other words, by far the largest determinant of IT sector performance in the bull market has been the upward movement of stocks in general.  (For what it’s worth, by far the largest losing sector has been Energy, which comprised 11.6% of the S&P 500 back then.)

Still, there have been spectacular winners, both individual stocks and subsectors, in IT.  So taking the time and effort to study IT stocks can pay big dividends.

placing IT in a business cycle context

Let’s group stocks by the sensitivity of their profits to the ups and downs of the business cycle, starting with the most aggressive (meaning most sensitive) and ending with the most defensive.  This is my list:

most aggressive

Materials

Energy

IT

Industrials  (this would be #3, except US industrials make mostly consumer            products)

less aggressive 

Consumer discretionary

Real Estate (this would be #4, except that a lot of the publicly traded vehicles are income-                            oriented REITs)

Financials

defensive

Healthcare

Staples

more defensive

Telecom

Utilities.

I’m sure that the lists others would come up with would rank the sectors differently.  Try it yourself and see.

What I make of my list is that IT will likely outperform anything lower on the list during an economic upturn and underperform during a downturn.

Two reasons:

–most consumer IT purchases, like a new smartphone or a new PC/tablet, are discretionary and can easily be postponed when times are tough, and

–for many modern corporations, capital spending means software.  And, in my experience, no matter how they say they maintain steady investment in their business, companies rarely outspend their cash flow.  When bad times lessen cash flow, companies–despite their promises–cut capex (i.e., software) spending.  Consumers, on the other hand, are much less draconian in their cutbacks, at least in the US.

 

Tomorrow, secular trends.