Stable condition

The technology sector contracted when huge losses and lack of interest prompted groups to close or merge funds. But the asset class has outperformed most others over the past year so is the ailing sector set to recover? Adam Lewis investigates.

This time last year the health of the technology sector was called into question after several fund groups decided to shut their funds specialising in the sector.

Such was the lack of investor interest in the sector, and such were the monumental losses suffered after 2000, that Aegon and Old Mutual decided to merge away their specialist tech funds. Then in February Investec closed its Global Technology fund and created a new fund – Global Dynamic Equity.

Meanwhile, in the preceding period, funds investing in just about every conceivable asset seem to have been launched, including agriculture, energy, clean energy, timber, property and even music rights. However, ask an average investor to diversify into technology and you will probably be met with a nervous reaction.

In the funds industry, every time a sector or geographic region looks as if it could be overheating, it is compared with the bursting technology, media and telecoms (TMT) bubble of 2000. That seems to have become the yardstick for failure.

The disappearance of funds leaves an Investment Management Association (IMA) Technology sector of just 11 funds, with, in August 2008, assets under management of £687m, according to the IMA. In May 2001, when the IMA included technology and telecommunications funds as a separate sector, the sector was £2.57 billion strong.

So has anything changed a year on that could make investors start looking at the sector more positively again? Or, if the world is heading into recession, is it best to give it a wide berth?Over the past 12 months to September 25, the Nasdaq Index has fallen 22.8%, compared with the S&P 500, which is down 20.3% and the MSCI World index, which has declined 21.7%. However, more encouragingly, according to SocGen the Nasdaq Composite has outperformed the S&P in five of the past six months (to August).

Indeed, according to Stuart O’Gorman, manager of the Henderson Global Technology fund, barring the energy and materials sectors, technology has outperformed most other asset classes over the past year.

Despite this, Hugh Grieves, the manager of the SG Technology fund, admits investor interest in the sector remains low. Much of this shunning, he says, is a result of the negative connotations of the asset bubble that grew in the 1990s and then burst spectacularly in 2000.

“With tech being the one bubble many people have experienced, I thought no one would touch it again until we saw other asset bubbles burst,” says Grieves. “However, since 2001 we have seen other sectors can have bubbles, namely commodities, emerging markets and property, all three of which are in various stages of being deflated.

“So while tech remains in the sin bin, people can look at what happened more objectively and understand it happens in other sectors as well.”

O’Gorman says multiple fund launches in any particular sector are a lagging indicator of how well that asset class is performing. For example, he says in 1998 there were only five technology funds in Britain while there were more than 30 in 2000 when the sector burst.

In the past year no technology funds have been launched, such is the lack of interest. In addition, Hitesh Thakrar, the manager of the New Star Technology fund, says fund flows have been similarly static. Investors have generally maintained their holdings but little new money has flowed in.

“There have been no new funds, but no funds have closed in the past year,” says Thakrar. “So the peer group has stabilised and performance has improved.”

According to Morningstar, over the 12 months to September 29 the average fund in the IMA Technology & Telecoms sector has fallen 17.59%. To put this performance into context versus other IMA sectors over the same period. UK All Companies fell (20.2%), UK Equity Income (down 20.62%), Global Emerging Markets (down 22.38%) and Asia Pacific ex Japan (down 28.04%) sectors.

The performance also outstrips the IMA Europe ex UK, European Smaller Companies, UK Smaller Companies and Japanese Smaller Companies peer groups. Does this suggest that technology funds are more resilient in a downturn than was previously the case, and are investors wise to continually ignore the sector?O’Gorman says technology funds will perform better than average in a rising market, but in a falling market, he adds, factors such as strong cash generation, healthy balance sheets and less competition mean the sector should also outperform.

“If the global economy goes into a recession the average investor expects tech to get murdered,” says O’Gorman. “However, while the sector may go down it won’t get as murdered as other sectors. This is because valuations are at historic lows, the companies are carrying no debt and they are awash with cash.

“All the other sectors in the world have debt that will have to be refinanced at higher interest rates. However, in the past few weeks both Microsoft and Hewlett Packard (HP) announced large share buybacks (Microsoft’s was $40 billion and HP’s was $8 billion), which shows how much cash companies have on their balance sheets.”

Jeremy Gleeson, the manager of the Axa Framlington Global Technology fund, says one of the most significant factors underpinning the sector’s resilience is that capital spending has been tightly controlled in recent years, with purchases being made on a strictly “as needed” basis.

This, he says, differs wildly from the over-spending and subsequent inability to digest the huge excess capacity which “characterised the build-up and ultimate bust of the dotcom bubble”.

Grieves says in terms of valuations technology is close to being at its cheapest level for 15 years, but it still trades at a discount compared with the S&P 500.

“Everyone is very pessimistic on the outlook for the US economy and the US stockmarket and tech is still seen as an economically sensitive sector,” explains Grieves. “As a result it has been sold down hard. The flip-side is that if we get a mild recession compared with the hard recession being priced in, tech should do well.”

Speaking before the rejection of the American financial bail-out plan, Grieves was unsure about whether or not America would avoid a protracted recession. This is because, he says, talking to companies provides a different picture than sentiment on Wall Street suggests.

To date, says Grieves, four companies, including HP and Microsoft, have announced a total of $53 billion (£30 billion) of share buybacks. Any more of these, he adds, would be a great show of faith in the economy.

He adds: “A second positive sign is Warren Buffett’s recent investment into Goldman Sachs. A lot of people will be encouraged by this.”

However, according to Grieves, sentiment towards the American stockmarket is at its worst level since 1995, with many investors giving up on it. However, he says there are threecatalysts that could turn this sentiment around. The first would be for the American financial sector to sort out its balance sheet. The second catalyst is that companies’ third quarter results will be reported this month, which he estimates will not be as bad as many expect.

Finally he says if John McCain wins November’s American presidential election it would be welcomed by the market as the Republicans are seen as more “business friendly”.

Despite these catalysts for a potentially brighter future most tech managers are adopting a cautious stance in their portfolios at present. One reason for this is the expectation of upcoming earnings downgrades, as analysts seem to have overshot on their predictions for 2009 earnings growth.

Another reason for caution is the pressure the tech sector is coming under from hedge funds as a result of the recent Financial Services Authority ban on the shorting of financials.

As a result the hedge funds are choosing instead to short tech funds, which Grieves says is causing forced selling, putting downward pressure on the market. He expects this to continue until the end of the month.

Gleeson says the companies most susceptible to the downturn are those dependent on consumer spending. In particular, those companies that are not able to show strong product cycles.

However, Francis Hudson, a global thematic strategist at Standard Life Investments, says the technology sector is huge and is not all about what goes on in the consumer area. She says the sector ranges from semiconductors to the sophisticated tech dependent on consumer spending, and in between is a whole raft of tech that relies on different market drivers.

“The semiconductors are more closely aligned to the business cycle,” says Hudson. “The latest reports from the Far East suggest these companies are not looking to add capacity, which indicates they are not through their problems yet, but the market remains very competitive. In the middle you have the tech companies you think will do badly in a downturn because of a lack of corporate spending. However, take the financial services industry, a huge buyer of tech. At the moment because of the regulatory changes prompted by the introduction of Basel II [capital adequacy requirements] and cross-border fraud protection they are having to spend more on tech.”

Hudson says tech is also a play into the expansion of emerging markets, in terms of installing tech infrastructure, such as automated teller machines (ATMs).

Thakrar says while the environment for the companies exposed to the consumer end of the market is likely to toughen as consumer spending slows, the corporate spending environment remains solid.

He says: “About 70% of the output from semiconductors goes into consumer electronics, meaning if consumer confidence remains weak there will be a slowdown in sales. However, the corporates have a lot of cash and are spending this on software and services.”

Grieves says his fund has increasingly become biased towards corporate demand (software, hardware and networking equipment) and moved away from the consumer areas of the market (wireless, flat-panel televisions and notebooks).

In August several tech bellwether companies reported their quarterly results, including Cisco, HP and Dell. Grieves notes that all three reported results that showed a quarter-over-quarter pick-up in American corporate sales, supporting the group’s thesis that American enterprise spending may be over the worst.

However, he adds that enterprise spending outside America has weakened slightly as European and Asian companies have become more cautious.

Hudson agrees that the consumer end of the market is feeling the pressure on its margins. For exampleshe says that in a competitive market the prices of flat-panel televisions have fallen rapidly. “The robust performance in the corporate end of the market may be a surprise to some, but logically it should be expected,” she adds.

One concern noted by Thakrar is that tech companies typically perform well in the second quarter and third quarter of the year, but then slow down after Christmas, when people stop spending money. As a result, he says, the sector comes under pressure in quarters four and one as most companies have already spent their tech budgets by then.

“Right now our fund is more invested in the large caps,” says Thakrar. “This is because they can protect more in a downturn. It is our view that until the analysts’ numbers start coming down, which we expect to happen in the next few weeks, having a fairly defensive portfolio is the right way to go.”

Phil Collins, the manager of the Newton Phoenix Multi-Asset fund, says he plays tech through investing in mobile phone stocks. He notes that while consumers in Britain may not have the money to buy a new handset, there is an increasing usage in data transfers (sending emails, pictures and so on) rather than voice transfers.

“This provides a regular revenue stream that does not depend on people buying new phones,” he says. In addition, he points to the growth in mobile handsets in the emerging markets.

So where geographically are people investing? O’Gorman says he is avoiding Japan and Asia as he says the tech companies there are more heavily exposed to the consumer areas. The only company he really likes in Japan at present is Nintendo. “In this environment we prefer the guys at the top of the food chain,” he says.

Grieves says his fund is biased towards America and away from Europe and Asia. This is because he says American valuations are more attractive and also because, as it was the first economy to go into a slowdown and the first to resolve its problems, by rights it should be the first to begin a recovery.

“Companies in Japan depend on consumer discretionary spending,” says Hudson. “As a result they face a tough time and outlook. They also face increased competition from the rest of Asia. As such it is the classic tech-heavy market that may do less well right now.”

In contrast, she says tech in America is spread across many different sectors, meaning it is tougher to get a clear view of what will happen next.

What is easier to read however, she adds, is just how the tech sector has evolved since 2000. She says compared with the bubble that emerged in the 1990s, the sector no longer has the prominence it used to have.

She says: “The tech sector as it stands today is different to what it was before the bubble. For one, it is a much smaller part of the listed market.”

For example, she says several mergers in Britain have seen the sector shrink, with Sage being the largest company listed on the FTSE 100, ranked 72. Meanwhile, in Germany, she says the large number of tech companies that used to dominate the smaller companies market have still not migrated across to the main market.

“Tech companies have grown up,” says Hudson. “Today the focus is much more on cash flows and earnings, whereas before people were trying to value ideas as the companies had no earnings, and this is always difficult to do.

“When the bubble burst the stocks at the top were operating with fictional earnings and their valuations were not based on anything real. Since then investors have become more discriminatory about what they invest in. It is no longer about looking for the new paradigm. Instead, we have a much more mature sector that may be less exciting but is likely to go boom and bust. Technology operates in the real world. “As a result of consolidation within the sector in recent years, O’Gorman adds that tech companies operate with much more stringent pricing disciplines than they did in the past. “During the tech bubble there was a huge amount of irrational competition,” he says. “Most of these companies have gone bust or have been bought so pricing is more oligopolistic.”

O’Gorman adds: “Tech still has the perception that because it was hurt in the last recession it will happen again this time around. However, the marketplace today is different to seven years ago and this is a very different recession to 2001-02. This recession is much more general, which will touch all areas of the global economy.”

With this in mind O’Gorman says while tech should not dominate an investor’s portfolio, at least a 5-10% weighting in the asset class would provide some diversification.

Hangovers from investing in asset bubbles are nothing new. However, after eight years of suffering, and with potential bubbles emerging elsewhere, perhaps the headache caused by tech may be ready to lift.

James Daly, investment centre representative at TD Waterhouse.

“Technology is the dictionary definition of a bombed-out sector. As an execution-only broker we have seen no significant moves into tech funds and to my knowledge such funds have never been in the list of top bought funds. Instead, right now there is much greater client interest in mining and resources funds, Latin America and India. Instead of buying mutual tech funds we have seen investors tend to play the sector by trading individual tech stocks.”

Ben Yearsley, senior investment manager at Hargreaves Lansdown.

“There is still no real demand for tech funds. It is one of those areas that because people got so badly burned, you wonder if they will ever go back into it in a meaningful way. Japan funds face the same problem, but I think it is worse for tech. This isn’t great because there will be a time to buy it again but investors have been put off by the history. We do have a tech fund on our Wealth 150 list of recommended funds, the SG Technology fund, but I can’t remember a time when any tech funds have forced their way into our top 20 funds bought on a monthly basis. Lots of other more general funds will have exposure to tech so that is the way it seems most retail investors are willing to play the sector.

Gary Potter, joint head of multi-manager Thames River.

“Tech funds still carry the excess of all the hype from the new millennium. We think the best way to play this sector is via more mainstream funds/managers, who can go in and out of the sector as necessary. I do not really see a large future for tech only funds. The natural resources story is a bit different because within these companies you can see genuine earnings. The TMT sector grew up purely on the basis of the coming of the new millennium. I accept tech is a big part of markets in practical terms in driving society forward to being more productive. I just think that sector funds such as tech should occupy less of people’s portfolio than they do in reality.