Check out my sector overview on Reuters Insider here.
The Information Technology sector ranks second out of the ten sectors as detailed in my Sector Rankings for ETFs and Mutual Funds report. It gets my Neutral rating, which is based on aggregation of ratings of 27 ETFs and 130 mutual funds in the Information Technology sector as of January 20, 2013. Prior reports on the best & worst ETFs and mutual funds in every sector are here.
Figures 1 and 2 show the five best and worst-rated ETFs and mutual funds in the sector. Not all Information Technology sector ETFs and mutual funds are created the same. The number of holdings varies widely (from 24 to 428). This variation creates drastically different investment implications and, therefore, ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst ETFs and mutual funds, which allocate too much value to Neutral-or-worse-rated stocks.
To identify the best and avoid the worst ETFs and mutual funds within the Information Technology sector, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expenses of each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.
Investors should not buy any Information Technology ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this sector, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off. Here’s the list of our top-rated Information Technology stocks.
Get my ratings on all ETFs and mutual funds in this sector on my free mutual fund and ETF screener.
Figure 1: ETFs with the Best & Worst Ratings – Top 5
Sources: New Constructs, LLC and company filings
Fidelity MSCI Information Technology Index ETF (FTEC) is excluded from Figure 1 because its total net assets (TNA) are below $100 million and do not meet our liquidity minimums.
Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5
Sources: New Constructs, LLC and company filings
First Trust NASDAQ Technology Dividend Index Fund (TDIV) is my top-rated Information Technology ETF and Oak Associates Red Oak Technology Select Fund (ROGSX) is my top-rated Information Technology mutual fund. Both earn my Neutral rating.
PowerShares Lux Nanotech Portfolio (PXN) is my worst-rated Information Technology ETF and Rydex Series Electronics Fund (RYELX) is my worst-rated Information Technology mutual fund. PXN earns my Dangerous rating while RYELX gets my Very Dangerous rating.
Figure 3 shows that 63 out of the 578 stocks (over 21% of the market value) in Information Technology ETFs and mutual funds get an Attractive-or-better rating. However, zero out of 27 Information Technology ETFs and zero out of 130 Information Technology mutual funds get an Attractive-or-better rating.
The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Information Technology ETFs hold poor quality stocks.
Figure 3: Information Technology Sector Landscape For ETFs, Mutual Funds & Stocks
Investors need to tread carefully when considering Information Technology ETFs and mutual funds, as most of them hold many poor stocks. No ETFs or mutual funds in the Information Technology sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive rating. Investors would be better off focusing on individual Information Technology stocks instead.
Western Digital (WDC) is one of my favorite stocks held by Information Technology ETFs and mutual funds and earns my Very Attractive rating. WDC has a return on invested capital (ROIC) of 24%, which puts it in the top quintile of all companies I cover. Moreover, WDC has grown profits (NOPAT) by 41% compounded annually since 2002 and has a high free cash flow yield of 14%. Western Digital’s stock was up over 94% in 2013, and is up 39% since I recommended it last June, but there is still value to be had. Shares currently trade at ~$89, which gives WDC a price to economic book value ratio of 1.0. This implies that the market expects Western Digital’s profits to never increase from their current level. This seems unlikely given WDC’s consistent track record of profit growth and recent revenues on the high end of management guidance. Investors should give this dividend stock a serious look before it becomes too expensive.
Tangoe (TNGO) is one of my least favorite stocks held by Information Technology ETFs and mutual funds and earns my Very Dangerous rating. Tangoe has a return on invested capital of just 4%, which puts it in the bottom quintile of all companies I cover. In addition to $22 million in reported debt, the company also has $19 million in off-balance sheet debt. The company is also losing its competitive advantage by lagging behind its peers in terms of ROIC, gross margins and NOPAT margins. As I wrote in October, insiders and institutional investors are beginning to sell off the stock, and the telecom software as a service field is becoming increasingly crowded and competitive. This trend is reflected in TNGO’s declining operating profits (down 23% since 2011) and NOPAT margins (down to 3% from 5%). Despite these warning signs, TNGO still trades at ~$19. To justify this price, TNGO would need to grow revenues by 20% compounded annually for the next 20 years. Based on these growth expectations, it seems the market has been fooled by TNGO’s acquisition-based growth while overlooking the the company’s eroding profitability. Investors should avoid TNGO.
513 stocks of the 3000+ I cover are classified as Information Technology stocks, but due to style drift, Information Technology ETFs and mutual funds hold 578 stocks.
Figures 4 and 5 show the rating landscape of all Information Technology ETFs and mutual funds.
My Sector Rankings for ETFs and Mutual Funds report ranks all sectors and highlights those that offer the best investments.
Figure 4: Separating the Best ETFs From the Worst ETFs
Figure 5: Separating the Best Mutual Funds From the Worst Mutual Funds
Review my full list of ratings and rankings along with reports on all 27 ETFs and 130 mutual funds in the Information Technology sector.
André Rouillard contributed to this report.
Disclosure: David Trainer and André Rouillard receive no compensation to write about any specific stock, sector or theme.