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ETF Specialist

Take a Small Bite of a Cheap Apple With This ETF

Apple and many other large-cap tech names are trading at attractive valuations.

Morningstar's Take
The share prices of some large-cap United States technology companies have been battered in recent months, amid a global macroeconomic malaise, uncertain prospects for some players, and very negative market sentiment toward certain corners of the tech space.

These declines represent a buying opportunity for investors, as the technology sector now has become undervalued in aggregate, according to Morningstar's equity analysts. Our analysts assert that recent sell-offs now mean that several tech titans, such as  Intel (INTC),  Microsoft (MSFT), and  Apple (AAPL), are priced to reflect long-term secular declines in their business. And while the PC market, which Intel and Microsoft serve, may well be struggling and in decline, investors should note that Intel and Microsoft have exposure to many other growing areas of technology. More broadly, for a longer-term investor to be comfortable with currently sagging valuations in the tech space, that investor would need to believe that neither Intel nor Microsoft nor Apple will be able to capitalize on growing global demand for computing devices.

For those investors willing to take a contrarian view relative to current market sentiment, an exchange-traded fund is a very appropriate way to invest in the large-cap U.S. technology space, as a basket of companies offers some diversity relative to single-stock investing and thus limits risk.

An ideal technology ETF is  Technology Select Sector SPDR (XLK), which is a market-capitalization-weighted basket of 78 large- and mid-cap technology firms that trade in the U.S. Right now, XLK is relatively undervalued and is one of the cheaper equity sector ETFs of any kind. Currently, XLK trades at 89% of fair value, which is relatively attractive compared with the broad market as a whole. For instance, the broad-market  SPDR S&P 500 (SPY) presently is trading at 95% of fair value.

Technology Select Sector SPDR offers investors broad exposure to the technology sector. As a sector-specific ETF, XLK should be viewed as a tactical investment, suitable only for the satellite portion of a diversified portfolio. XLK holds large-cap names, so it is not suited for investors looking for exposure to more speculative small- and mid-cap tech firms. This fund is very top-heavy; the top-10 holdings account for more than 63% of the portfolio. And XLK has a very high-quality portfolio: Wide-moat and narrow-moat firms account for about 48.5% and 44% of assets, respectively. In other words, Morningstar's equity analysts believe that more than 92% of the firms held in XLK have sustainable competitive advantages.

Asset allocators should note that XLK's holdings together make up almost 19% of the S&P 500. Despite the seemingly low overlap, XLK has displayed a 93% correlation to the S&P 500 over the past five years. Going a step further, we wouldn't recommend this fund to investors who own the popular  PowerShares QQQ (QQQ), commonly referred to as the Cubes. The two ETFs show a 98% correlation over the past five years.

Fundamental View
Tech firms continue to benefit from long-term trends like cloud computing, mobility, and consumerization. IT spending generally has been resilient, and we expect players exposed to the aforementioned trends will do well even if the demand environment weakens. Right now, the tech sector has been struggling because of broader global macroeconomic weakness and negative market sentiment surrounding the PC supply chain. However, some of the biggest players in the PC space also benefit from strong growth in other, non-PC areas of technology, such as tablets and smartphones. And industry titans such as Intel and Microsoft have strong pricing power in the PC supply chain and stand to generate substantial free cash flows even if the PC market continues to shrink.

Apple makes up 16% of the assets of this ETF and as such warrants a closer look. The stock shed nearly one fourth of its value between Sept. 19, 2012, and Jan. 8, 2013, as investors got spooked. Why? As my colleague Dan Culloton noted recently, it could have been anything from concerns about increased tablet and mobile-phone market competition, efforts to realize capital gains before higher tax rates kicked in, or even reversion to the mean. However, our equity analysts fall down on the side that Apple's share price has been excessively punished and that baked into the company's current valuation are very pessimistic expectations for iPhone demand in early 2013, especially in emerging markets. In our analysts' view, even with no chance of a blowout first quarter of 2013, some of the much-reported supply chain bumps may not be especially closely tied to sales to end customers. And given the potential for better-than-expected iPad growth and other possible new innovations related to Apple TV, Apple's risk/reward profile looks promising for investors at current levels.

Large tech players also can expect to benefit from continued strong demand growth for smartphones, both in the developed world and in emerging markets, driven by better products and improved mobile Internet applications, as well as a continued shift into cloud computing and virtualization. What do these shifts portend for existing players? Certainly cloud computing is a real threat to  Oracle's (ORCL) applications business, although the company is working to develop cloud versions of its legacy products and is doing a solid job of reworking customer contracts to induce clients to transition from legacy applications to cloud solutions. Microsoft is trying to compete in the cloud through its Office 365, which the firm hopes will be adopted by customers already comfortable with its Windows franchise.

Cloud computing seems less of a risk to  IBM (IBM) (but still a risk), as the company is maintaining a solid position in enterprise software, services, and hardware. IBM also is doing a solid job competing against Oracle and Microsoft in databases, and the company has wisely exited more commoditylike areas of hardware. All told, we like IBM's strong customer relationships and see them as a bulwark to protect the company's competitive position.

In our view, an overwhelming majority of companies included in this ETF have displayed resiliency and should continue to be nimble enough to succeed in the face of rapid innovation, short product cycles, and unpredictable consumer and corporate spending--issues that drive volatility in the tech sector.

Portfolio Construction
This fund is one of nine Select Sector SPDRs. It tracks the technology sector of the S&P 500 Index and holds 78 companies. XLK's holdings are based on a modified market-cap-weighting methodology, and the top-10 holdings account for a very significant 63.5% of the total portfolio. The top five holdings are Apple (accounting for almost 16% of the total portfolio), Microsoft (7%), IBM (7%),  Google (GOOG) (7%), and  AT&T (T) (6.5%). The largest subsector weightings are computers and peripherals (25%), IT services (17%), software (15.5%), and telecom services (13%). The average market cap of XLK's holdings is almost $95 billion.

This ETF carries a 0.18% expense ratio, which is cheap relative to similar technology funds.

Investors seeking exposure to the tech sector can consider  Vanguard Information Technology ETF (VGT) and  iShares Dow Jones US Technology (IYW), which carry expense ratios of 0.14% and 0.47%, respectively. These funds and XLK are almost perfectly correlated but do have small portfolio differences. In addition to information technology companies, the Vanguard ETF has a 10.5% allocation to IT services companies like  Visa  (V) and  Accenture (ACN). The Tech SPDR has a 12% allocation to telecom services companies such as AT&T. The iShares fund does not hold any telecom services or IT services companies and therefore can be considered the pure-play broad technology ETF.

The tech-heavy PowerShares QQQ (0.20% expense ratio) is also a suitable alternative as it has a near-perfect (98%) positive correlation with XLK, thanks to its 63% exposure to the tech sector.

For those looking for a heavier weighting of mid- and small-cap tech firms with potentially brighter growth prospects, we suggest Guggenheim S&P 500 Equal Weight Technology (RYT), which carries an expense ratio of 0.50% and is very thinly traded. Investors also can consider PowerShares S&P SmallCap Information Technology Portfolio (PSCT), which carries an annual expense ratio of 0.29%.

The aforementioned funds only invest in U.S.-domiciled firms, but it's important to note that there are major overseas-domiciled global technology players as well, such as Samsung Electronics,  Nokia (NOK),  Taiwan Semiconductor (TSM), and  Canon (CAJ). Funds that have exposure to overseas firms are  iShares S&P Global Technology (IXN) and SPDR S&P International Technology Sector . The expense ratios for these funds are 0.48% and 0.50%, respectively.


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