Is it time for investors to buy tech stocks?

Is it time to buy technology stocks? After a heavy tech sell-off this year, are there bargains among the big tech names? The short answer: No. The long answer: There are always opportunities in a sector as large and diverse as tech. Within tech, biotech looks interesting after recent falls. Asian tech stocks also appeal on valuation grounds but suffer from sovereign risk.

With the Nasdaq 100 index down almost 16% this year, it’s tempting to add tech exposure to portfolios. Yes, there will be a time to buy tech, but long experience has taught me that sectors often fall further – and for longer – than investors anticipate.

The tech sell-off has coincided with an inflation outbreak in the US and expectations of interest-rate rises. Rate hikes are bad for long-duration growth stocks like tech. Higher rates reduce the present value of future cash flows – and thus tech valuations.

Some US investment banks expect the US Federal Reserve to raise rates another six times this year and a few times next year. An expected terminal rate of 2.5% might prove too low to tame annual US inflation that is approaching double digits.

It’s hard to see the tech sector outperforming anytime soon when inflation and interest-rate risks are on the upside. That could change if inflation moderates and the market realises it is too bearish on the rate outlook. I don’t see that happening.

Hard and soft commodities, banks and companies with higher pricing power, such as utilities, are the best bets when inflation rises. This is a market for defensive investing or a “flight to essentials”, as one fund manager recently put it.

I know some tech bulls will dislike my view. They’ll point to fabulous tech companies trading 20% or more below their peak valuation. They’ll argue that artificial intelligence and other emerging technologies are changing the world. They might even argue that companies with the best pricing power – think Netflix – are tech.

They’re right, of course. But market sentiment is a powerful force. Right now, it’s against tech and we are in the first innings of a new rate-hike cycle. Moreover, history shows the best-performing sector in the previous decade inevitably underperforms.

Biotech appeals

Like the information-technology sector, biotech has underperformed this year amid the rotation from growth to value stocks.

The S&P Biotechnology Select Index, a barometer of 156 US-listed biotech stocks, has fallen almost 33% over one year to end-March 2022. That compares to a 17% gain in the S&P 500 Index during that period. Biotech has been a terrible short-term bet.

Unlike information technology, biotech’s underperformance did not coincide with expectations of rising interest rates. After two cracking years, the biotech sector was due for a pullback or significant correction, which arrived last year.

The S&P Biotechnology Select Index returned 35% in 2020 and 33% in 2019. Several biotechs rallied during the COVID-19 pandemic as investors paid more attention to vaccine developers, pharmaceutical companies and telehealth providers. There was a rush of biotech Initial Public Offerings in the US during that period.

The biotech sector has now given back most of the gains made during COVID-19. The S&P Biotechnology Select Index is trading at levels last seen in early 2020. The gap between the biotech sector and the US share market has ballooned, as this chart shows.

Benchmark vs S&P500 (5-Year).

I love charts like the one above. Sector performance inevitably reverts closer to the mean after periods of unusually large outperformance or underperformance. That will be true of biotech in the next few years as the performance gap (shown above) narrows.

Few sectors have as much long-term potential as biotech. So many big breakthroughs in the next decade will have their origins in biotechnology. This is not just about medicine: biotech will drive innovations in agriculture, renewables and other sectors.

Expect more mergers and acquisitions in biotech this year. The smart money will pounce on sharply lower sector valuations. A new period of consolidation will position the sector for its next big growth phase – just as mainstream investors lose interest.

Biotech ETFs

When sectors badly underperform, I prefer using sector Exchange Traded Funds (ETFs) to build portfolio exposure rather than betting on companies. It’s easier to “buy the sector” through a low-cost ETF than trying to pick stock winners.

ETFs are especially useful with biotech investing. Australia has some terrific biotech companies, but the main action is overseas. You have to invest globally to get exposure to big pharma and other leading biotechs; that’s easier through an ETF.

Moreover, biotech investing has higher risk. By investing in a basket of stocks, ETFs provide instant portfolio diversification. You won’t get the big potential returns from owning a handful of biotechs – or the catastrophic losses that sometimes occur.

The ETFs S&P Biotech ETF (CURE) appeals. CURE provides exposure to US biotech companies included in the S&P Biotechnology Select Industry Index. About three-quarters of the ETF is invested in biotech; the rest is in healthcare providers.

Unlike traditional indices that weight companies according to market capitalisation, CURE’s underlying index weights companies equally. This reduces the effect of a small group of giant biotechs dominating the index weighting.

CURE suits experienced investors who understand the features, benefits and risks of investing in the biotech sector. In addition to drug-discovery risk, CURE has currency risk because it is not hedged for currency movements. About half of CURE is invested in small-cap biotech companies.

For investors with higher risk tolerance and long-term horizon (at least five years), the US is the place to invest in biotech. CURE is an easy, cost-effective way to do so.

ETF S&P Biotech ETF (CURE)

Stock price chart of ETF S&P Biotech ETF (CURE).

The VanEck Global Healthcare Leaders ETF (HLTH) is another option. Unlike CURE, HLTH invests across the healthcare sector. Roughly, HLTH is split between the biotech, pharmaceutical, life science tools and services, and healthcare equipment sub-sectors.

By country, just over half of HLTH is invested in the US. About 15% of the ETF is invested in Switzerland. By stock, most holdings in HLTH are large caps. This, plus greater country and sector diversification, reduces HLTH’s risk profile.

HLTH is a smart-beta ETF. It uses rules to identify the 50 largest healthcare stocks with the best GARP (Growth At a Reasonable Price) traits. Each stock is equally weighted.

Smart-beta ETFs have pros and cons, but factor-based ETF investing lends itself to biotech, given the risks. HLTH selects stocks based on four factors: growth, value, profitability and cash flow – rather than blindly following an index.

HLTH is down almost 11% over six months to end-March 2022. Like CURE, HLTH is a convenient, low-cost tool for investors who want to take advantage of sector weakness to add global healthcare exposure to their portfolio.

Nobody knows for sure when the biotech rout this year will end. Further short-term losses would not surprise given the poor sentiment towards the sector. Also true is that few investors pick the precise turning point after heavy sector falls.

After massive underperformance this year, biotech will appeal more to investors who can look beyond short-term market machinations to the sector’s long-term growth.

VanEck Global Healthcare ETF (HLTH)

Stock price chart of VanEck Global Healthcare ETF (HLTH).

Tony Featherstone is a former managing editor of BRW, Shares and Personal Investor magazines. All prices and analysis at 22 April 2022.  This information was produced by Switzer Financial Group Pty Ltd (ABN 24 112 294 649), which is an Australian Financial Services Licensee (Licence No. 286 531). This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice. This article does not reflect the views of WealthHub Securities Limited.