Individual investors »
Latest views »
Market updates »
Technology stocks stage a comeback - 03.04.2008
After years in the wilderness, technology is being welcomed back into the investment fold. The sector has struggled with its image since the technology bubble burst in 2000 but, with factors stacking up in its favour, investors are beginning to rekindle their interest.
The shift in sentiment began in 2007 as fears grew about a US recession. Investors sought companies with exposure to overseas markets, a group that includes many technology businesses. Emerging market economies appeared particularly resilient to any slowdown and their strong growth continued to drive demand for technology, especially for mobile phone handsets. Technology companies are less exposed to the repercussions of the credit crisis because they tend to have lower debts than companies in other sectors. In fact, balance sheets in the sector are much stronger than they ever have been, with nearly 10% of their market value in cash, the highest of any major sector. Given these attributes, technology stocks began to take on 'safe haven' status.
The continued fallout from the sub-prime lending crisis has led to a significant slowdown in corporate earnings growth in certain markets. While earnings growth forecasts for world markets have been pared back to about 12% for the next 12 months, technology companies are still expected to grow their profits by 18% globally this year. Last year, it appeared that consensus earnings per share growth forecasts for the technology sector were too high, at about 21%, and needed to fall. Now the sector is trading at more realistic levels, confidence in it is much stronger. The wider global earnings outlook is deteriorating and technology earnings may be under some pressure but they should still show above-average growth.
Most technology shares have been left behind in the past four years so valuations on some of the more attractive stocks have failed to keep up with these above average-growth prospects.
For the first time since 1999, investors have been favouring large stocks over small companies because the earnings outlook remains uncertain and they have been focusing on companies with stable earnings records. For example, the largest technology stocks, such as IBM and Cisco, are trading on similar valuations to other large companies; the difference is that these bellwether technology groups are predicting double-digit earnings growth for the year ahead. The weak dollar is aiding the strong earnings growth because about 65% of technology companies' revenues come from outside the US. At the end of 2007, the New Star Technology Unit Trust had approximately 45% of fund weighting in US tech stocks, and this is being increased, with a particular focus on industrial technology stocks.
The technology sector's above-average revenue and earnings prospects mean that investors see it as a growth area – and growth-oriented stocks have outperformed value holdings over recent months. As investors continue to switch out of value sectors such as energy and materials and reinvest in growth stocks, technology stocks should enjoy strong performance.
It is not all rosy for the technology sector and careful stock selection remains vital. Companies that rely on customers in the financial services industry could be vulnerable. In the event of a prolonged downturn, banking, insurance and real estate companies may curb spending on information technology. This may in turn hit the profits and share prices of some technology companies. Some reassurance, however, has come from reports that large US banks, including Merrill Lynch and Goldman Sachs, actually increased their quarter-on-quarter technology and communication spending in the fourth quarter of 2007.
Meanwhile demand in other areas has accelerated. Last year, liquid crystal display (LCD) suppliers cut back capacity, building fewer factories and slowing production, but major players, including Samsung and LG Philips in Korea, AU Optronics in Taiwan and Chi Mei in China, recently announced increased capacity growth to meet high demand for flat panel televisions this year. The New Star Technology Unit Trust has added to its position in Corning, a US company that provides the glass for flat panel televisions, because it stands to benefit from the increased activity.
Further proof of support for technology can be found in continued merger and acquisition activity. In January, competition heightened in the search engine market, with Google at loggerheads with Microsoft over its hostile bid for Yahoo. Google has about a 65% share of the search engine market while the combined market share of Yahoo and Microsoft is around 20%. At US$44.6 billion (£22.6 billion) Microsoft’s bid for Yahoo was not only at a premium but also marked the largest deal the internet sector had seen since the height of the dotcom boom. Google stands to gain from the bid activity because it is so closely bound up with the fortunes of its two rivals. It now has a chance to consolidate its position as Microsoft focuses on attempts to strengthen its loss-making search business.
Consolidation in the sector is not only benefiting the companies directly involved. Nokia has been among the New Star Technology Unit Trust’s top 10 stocks for about six months and now has a market share of about 40%. Its closest competitor, Motorola, issued a significant profit warning and may sell its handset division. That would represent a good opportunity for Nokia because the company that ultimately buys Motorola’s arm business will spend some time redeveloping and restructuring it. The stock ended January trading at an attractive price/earnings ratio of 13 while competitors in the handset market such as Research In Motion and Apple were on multiples between 25 and 35.
The outlook is promising. Technology stocks tend to perform well in the latter stages of the economic cycle as rates of capital investment increase. The current cycle has been particularly strong as emerging market countries' spending on first-time technology assets is helping to offset the US slowdown. Moreover, technology stocks should respond well to the recent interest rate cuts because they tend to be one of the strongest performing sectors following reductions.
