By Ben Eisen and Akane Otani 

Investors rattled by recent volatility are becoming choosier about which technology-focused stocks they scoop up, a reversal from 2017 that threatens to undermine the tech sector's dominance in the long stock rally.

The S&P 500 tech sector, up 1.8% in 2018, is still among the best-performing groups in the broader index. But more than a third of the 69 stocks in the sector have declined in 2018, the most for any full year since 2011. In 2017, only six of them had lost ground.

The divisions are likely to come into sharper focus as more tech-focused companies report financial results in the coming days. With valuations already stretched by traditional measures, investors are contemplating which companies warrant the higher multiples that typically come with the tech label. After all, advanced technology underpins nearly every business, from banking to manufacturing, investors say.

The moves mark a period of more careful scrutiny among investors following a year when any name with a Silicon Valley ring to it seemed to rise -- be they video-streaming services, auto makers or computer companies. Netflix Inc. rose 55% in 2017, while shares of Tesla Inc. and Apple Inc. both surged 46%.

Netflix, though lumped into the consumer-discretionary sector, has climbed 59% this year as its video-streaming service has continued to post subscriber growth. But Tesla, the electric-car maker run by Elon Musk that isn't in the S&P 500, is down 9.9% amid concerns about the pace of production of its new Model 3. Meanwhile, Apple has fallen 3.3%.

"It's more of a prove-it-to-me market," said Brian Johnson, the chief investment officer at Viridian Advisors in the Seattle area, which has roughly $600 million in assets. "We've had tremendous gains over the last year or two."

Mr. Johnson's firm sold its stake in Tesla last month amid concerns about Model 3's production pace. He noted that sentiment around the stock had soured after its remarkable run in 2017. The firm, however, still holds some big tech stocks.

"A lot of people have trouble defining exactly what these companies are, " said Dan Roarty, chief investment officer for thematic and sustainable equities at mutual-fund firm AB. "They cross a lot of boundaries."

After its run-up in 2017, the S&P 500 tech sector trades at roughly 31 times its past 12 months of earnings, carrying among the highest price/earnings ratio of the 11 sectors in the broad index. The S&P 500 trades at 22 times trailing earnings.

Rising valuations have made certain areas of the tech sector look less appealing, investors say, especially given the possibility that regulators could move to impose tighter rules on companies ranging from social-media giants to self-driving-car makers.

Facebook Inc., which had been the fifth-largest S&P 500 firm by market capitalization earlier this year, tumbled in March as lawmakers blasted the company's handling of its users' data -- raising fears among investors that firms heavy on data collection could get hit by stricter regulations.

That is when AB's Mr. Roarty dumped the last of his Facebook holdings. A basket of big tech stocks that last August made up more than 11% of his portfolio now makes up about 6%, he said. Shares of Facebook jumped in after-hours trading Wednesday after the firm said revenue and profits rose in the first quarter despite backlash over its handling of user data. Still, Facebook shares remain down 9.5% this year through Wednesday's close.

This week, Google parent Alphabet Inc. reported profits for the first three months of the year that topped expectations, but investors grappling with the company's higher expenses sent the shares down 4.8% Tuesday, its worst session in more than two months. Twitter shares fell 2.4% Wednesday after the company warned revenue growth likely will slow for the remainder of the year.

Other investors have backed off the so-called FANG trade -- a bet that Facebook, Amazon.com Inc., Netflix and Alphabet will continue rising in lockstep -- and gravitated toward names that they feel aren't part of crowded trades.

Thomas Plumb, president of Wisconsin Capital Management, has grown fond of companies involved in financial transactions -- ranging from household names like Mastercard Inc. to the Maine-based Wex Inc., which helps trucking companies process payments. Both stocks are up more than 11% for the year.

Meanwhile, Brian Culpepper, a portfolio manager at James Investment Research, favors lesser-known companies like Western Digital Corp., a computer that manufactures data-storing devices, including hard drives. Shares of Western Digital have climbed 8% in 2018.

"I really worry about the stocks that have run drastically higher -- the FANG stocks. Those are probably the names that would be hit the hardest in any decline," Mr. Culpepper said, adding that he believes there will be a growing divide in hardware-producing tech companies and social media-oriented tech firms.

This fall, index providers S&P Global and MSCI Inc. will reclassify Facebook, Alphabet, and some other current tech constituents as communications companies, lumping them in with the likes of entertainment company Walt Disney Co. and media conglomerate CBS Corp. After the changes go into effect, none of the so-called FANG stocks will be in the tech sector.

That stands to reduce the sales and earnings growth of the remaining tech sector, potentially reducing its appeal to some investors, according to Goldman Sachs Group. The sector, which will still include Apple Inc. and Microsoft Corp., will make up about a fifth of the S&P index's market cap, down from about 25% currently.

Write to Ben Eisen at ben.eisen@wsj.com and Akane Otani at akane.otani@wsj.com

 

(END) Dow Jones Newswires

April 25, 2018 17:35 ET (21:35 GMT)

Copyright (c) 2018 Dow Jones & Company, Inc.
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