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The new view of technology

While one might be forgiven for thinking the investment community had lost

faith in the technology sector, in fact, the fundamentals for the sector

could hardly be better.

Technology stocks registered record earnings in the first quarter and the

majority of companies are very optimistic about the outlook going forward.

Currently, however, the mood of the overall market is not good, with major

concerns surrounding the macro-economic environment and, in particular,

inflationary levels in the US.

Although it is unlikely that the level of volatility, both intra-day and

day-to-day, will reduce in the near future, 85 per cent of companies have

reported earnings, according to Morgan Stanley&#39s technology universe. Of

these, 73 per cent reported earnings ahead of expectations, 11 pre cent

were in line and 16 per cent worse than expected. These are record highs

and lows. Since 1996, there has never been such a high percentage of

earnings ahead of expectations – nor such a low percentage of earnings

below expectations.

In other words, the earnings were excellent. This suggests this year

should be a great one for corporate profits. Moreover, these results

emerged from the first-quarter post-Y2K.

Our view is the technology sector in the US will remain range-bound in the

short-term as investors wait for further evidence about the outlook for

interest rates. Outside the US, there remains a high correlation between US

technology shares and Far Eastern and European shares. We would expect

investors to focus on high-quality, blue-chip names and away from unproven

management and business models.

The real difficulty, of course, is trying to estimate when the sector will

recover. It is the million dollar question. At the moment, the market is

still adjusting to the imbalances at the beginning of the year when some

investors were buying technology shares and selling everything else. This

is illustrated by the fact the Dow Jones Index underperformed the Nasdaq

Composite Index in February by the greatest amount in 30 years. Such

dramatic swings take a while to correct themselves.

As a result of this degree of volatility, investors remain nervous and the

market consensus is cash levels at institutions are high. These conditions

ought to lead to a strong recovery in the markets when confidence returns.

However, the summer is not a period when the market normally performs well.

Timing is always difficult but the reality is stocks are getting cheaper,

valuations are not demanding relative tohistorical levels and the outlook

for earn-ings&#39 growth remains both highly visibleand very strong.

With regard to valuations in the sector, Greg Smith, the US strategist at

Prudential Securities in the US, estimates the US technology sector is

trading at a Peg ratio of 1.8 times forward earnings, on average, which is

relatively fair value from a historical perspective. The technology sector

has always traded at a premium to its growth rate because the absolute

level of earnings&#39 growth from technology shares has exceeded that of the

general market. With earnings&#39 growth rates accelerating, we believe valuati

ons are attractive for long-term investors.

Looking forward, there is no doubt the recent volatility has created real

buying opportunities. However, the key is to focus on quality companies,

many of which do generate significant earnings. It is these quality

large-cap companies that should lead the recovery as investors become more

discerning about which technology stocks they should choose to participate

in the technology revolution.

We remain underweight in dotcoms – we did not, for instance, invest in

lastminute.com – where 80-90 per cent – business to consumers – will fail.

Boo.com is one such example. It was a nice idea with some decent products

but it did not have strong and proven management or a great business model

and its demise illustrates two key lessons

First, it is risky to invest in unproven management. Venture capital funds

make hundreds of investments and anticipate that many will fail. Second,

the press coverage of boo.com completely outweighed the importance of the

event. Regardless of the sector, many early stage companies go under, as do

most businesses with poor business models. So where is the surprise?

Technology remains an excellent medium- to long-term investment sector but

reality has returned and not everyone can make easy money.

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