Is Technology Select Sector SPDR a Buy?

The SPDR Technology Select Sector Fund (XLK) is an ETF that allows investors to buy a cross-section of the S&P 500’s tech companies.

Given the ongoing tech boom and investor enthusiasm around generative AI, this fund has the hallmarks of being a winner going in 2024 but the early January selloff sparked concern that the tide was going out for tech stocks. So which is it, buy or sell?

What Stocks Are In XLK?

XLK tracks a group of 64 stocks from the technology sector of the S&P 500, including hardware, software, service and other tech-related businesses.

On the cost side, XLK offers a reasonably low expense ratio of 0.10% for such broad exposure.

The Technology Sector Select Fund is a highly concentrated with over 40% of its holdings in just the two top stocks, namely Microsoft (NASDAQ:MSFT) and Apple (NASDAQ:AAPL). These two stocks account for 22.8% and 21.5% of XLK, respectively.

Other big holdings in the portfolio include:

• Broadcom (NASDAQ:AVGO): 5.1%
• NVIDIA (NASDAQ:NVDA): 4.7%
• Adobe (NASDAQ:ADBE): 2.9%
• Salesforce (NYSE:CRM): 2.8%

XLK’s tech focus has allowed it to beat the market in recent years but since its inception in 1998, the fund has returned an average of 8.8% annually, so its lifetime performance is somewhat below the long-term average of the S&P 500.

The last decade is where it has shined brightest. Over that period, XLK has returned an average of 19.9%. This performance has, however, come at the price of fairly high volatility. Over the last 52 weeks, for instance, the fund has traded from a low of $125 to a high of $194.

XLK’s focus on high-growth companies can make it more volatile, but the growth over the last several years has justified the frequent ups and downs.

Is XLK Fairly Valued?

Being a tech-focused fund, one might expect XLK to trade at unusually high premiums to current earnings. The forward price-to-earnings ratio for the fund as a whole is 27.2. Although much higher than the S&P 500 average of 21.6, this ratio isn’t excessive compared to many of the individual tech stocks that are found in the fund.

In large part, this relatively sensible P/E ratio is the result of XLK’s high concentration. Microsoft and Apple trade at forward P/Es of 33.3 and 27.6, respectively.

Several of the stocks within the fund, however, boast ultra-high valuations that make them far riskier for investors. NVIDIA, AMD and Salesforce, to cite three examples, carry respective forward P/E ratios of 44.4, 72.2 and 43.3. Fortunately for value-oriented investors, these stocks combined make up just 10% of the overall XLK portfolio.

Over the coming 3-5 years, the average annual earnings growth for the stocks in XLK is expected to be 13.5%. This double-digit earnings growth rate is a notable positive that has the potential to support even higher prices.

XLK Dividend Income Is Low

One area where XLK struggles is in its ability to produce dividend income. The fund’s 30-day yield is just 0.8%. Even in an era of historically low dividend yields, the overall S&P 500 still averages nearly 1.5%. As such, XLK is not a compelling choice for investors who are looking for income from their portfolios in the near future.

In terms of dividend growth, the fund could be a better long-term bet. Even though neither of the two top holdings offers a yield of over 1%, both have been raising their dividends steadily over the last few years.

Microsoft has averaged a 10.1% annual dividend increase over the last three years, while Apple’s average has been 5.6%.

Neither company’s dividend payout ratio is over 30%, suggesting that both have a great deal of room left for growth.

A third possible dividend growth driver within the fund is NVIDIA. With a current yield of just 0.03% and a payout ratio of 2.1%, NVIDIA’s dividend has barely started to take off.

While the stock itself may well be overvalued, the dividend growth NVIDIA could produce as it matures may make it an appealing minor holding in a fund like XLK.

Is XLK a Buy?

Although XLK is pricey, there is little doubt that the technology sector still has steam behind it when viewed over a longer term horizon. This is evident in the double-digit growth projected for the fund’s holdings over the next 3-5 years.

Assuming that technology stocks continue to add value and increase their earnings, investors are poised to do reasonably well by buying XLK.

It’s also worth considering that XLK provides diversification within the highly volatile world of tech stocks. While investors may not see the extreme gains that can come from investing in one ultra-successful tech company, they are also less susceptible to the volatility that can come with stocks trading at extremely high earnings multiples.

A final positive to XLK is the likelihood that tech stocks will gain if and when the Federal Reserve begins to reduce interest rates in 2024. High-growth companies tend to be more attractive to investors when interest rates are lower. As such, money could continue to flow into large tech companies as the Fed executes its three planned interest rate cuts throughout the year.

On the downside, it’s difficult to ignore the fund’s early performance in 2024. Year-to-date, XLK is down about 4.3%. The S&P as a whole, by contrast, has lost just 0.13%. This weak performance so early in the year is far from a death knell for the fund, but it could point to a choppy period ahead.

The fund’s concentration also presents risks for investors. Although Microsoft and Apple are both excellent companies that stand at the top of their industries, having each one account for more than 20% of XLK’s holdings could be a problem if one or both companies face significant hardship.

Ultimately, XLK is likely a decent buy for investors who are bullish on tech but looking for some protection from overvalued, high-risk single stocks. By investing in a diversified fund, they can access the above-average growth potential of the tech sector without relying on any one company’s technology to win in an ever-evolving marketplace.

Although it may not be a good fit for value investors or those concerned with immediate dividend income, XLK is appetizing to growth investors with long time horizons and moderately high risk tolerances.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.