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's 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' 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' growth from technology shares has exceeded that of the
general market. With earnings' 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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