It is startling how sentiment in the information technology sector has reversed course in the past week. Last week Google, Intel and eBay reported outstanding earnings, adding euphoria to the sector and pushing the S&P 500 Information Technology sector index up 5.3% on the week. This week, the story has changed. Even as the highly anticipated results from Apple and Microsoft were better-than-expected for the second quarter, their outlooks disappointed investors and sent shares lower. As of the close on Thursday, the tech index has declined 1.9% since last Friday (July 17).
We believe the indecisive investor reaction to tech sector earnings has a lot to do with how low the expectations bar was initially set for the sector. Heading into the second quarter reporting season growth expectations settled at 2.0%, well below the 11.5% growth anticipated at the start of the year and less than half the 5.3% expected when Q1 earnings kicked off in mid-April (by the way, the group beat Q1 expectations by 500 bps). Considering the 2.0% growth was only better than that of the industrials, utilities, consumer staples and energy, which all had negative or flat growth expectations, it’s fair to say the expectation was a low rate.
Information Technology Sector EPS Growth Progression
Source: S&P Capital IQ
Note: April 13th represents the start of Q1 2015 earnings season. July 13th represents the start of Q2 2015 earnings season.
The sharp decline in consensus expectations made it conceivable that the tech sector could actually end up easily exceeding dramatically diminished expectations. The respective 8% increases in Google’s share prices the week prior to their earnings announcements could have been an indicator of the optimism underlying the sector. Google delivered with strong results and an upbeat outlook, sending its shares sharply higher.
It appears that market participants likely entered this week with increased confidence in their enthusiasm for the tech sector. This, perhaps, elevated the expectations-bar for the group ahead of reports from Apple and Microsoft. Both companies did have respectable beats for the second quarter, but at the same time, provided guidance that apparently disappointed investor expectations which put pressure on these stocks.
That being said, only 37% of the tech sector has reported second results, indicating the line- in-the-sand regarding profitability has not yet been determined, one way or the other. We believe the tech sector will end the second quarter earnings season with a growth rate that is much better than the 2.0% rate initially projected, and also better than the current 4.1% rate.
As has been the case for many other sectors so far this year, it is proving to be very much a stock-pickers market. There likely remains plenty of value to be found in technology, with the group trading at a 25% discount to its 15 year historical average price/earnings ratio. Companies with fundamental growth opportunities, serving strong end markets, will be the best way to approach investing in the tech sector.
Please see our report titled “Feeling Hot & Cold On Technology Earnings,” published July 23, for additional detail on Q2 results for GOOGL, INTC, IBM, MSFT, AAPL, YHOO and their guidance vs Street expectations as well as valuation.