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The search for value tech

At a time when investors are cautioned to expect sub-par growth as world economies recover, many are turning to the momentum plays of old – technology. There are clearly compelling investment opportunities in the tech area and Google has proven that not all internet businesses are blue sky. However, is the Google example being taken too far and are investors once again getting carried away with the allure of high growth returns?

Since tech began its downward spiral in March 2000. the sector has been relatively out of favour with investors. At the height of the boom, the IMA tech and telecoms peer group featured dozens of offerings. Today, it has shrunk to just 11. However, the recent high-profile IPOs of internet companies – with the promise of potentially bigger ones still to come – may soon lead to a resurgence in this area.

Yet it is the valuations being given to some internet companies, particularly social media firms, and the perceived obscurity of their business models that is simultaneously sparking fears of another internet bubble. Twitter may be popular to use but some commentators wonder if the company is really worth an $8bn-$10bn valuation, especially on the back of its $110m forecast earnings? Online social games developer Zynga, formed in 2007, is also being valued at a similar amount. Neither is public just yet but talk of these valuation levels is concerning, particularly when existing IPOs are already reaping similar amounts.

Online professional networking company LinkedIn floated this month and its IPO price rose by 90 per cent to value it at almost $9bn. The company is reported to have earned only $3.4m in 2010, so on May 19 its reported price/earnings multiple was said to have surpassed 500. By comparison, more established companies such as Google and Apple are on p/e multiples closer to 15. Is all this sounding familiar? Many commentators seem to think so, with several articles alluding to the fact we have not seen such heady valuations since the 1990s.

Dmitry Solomakhin, portfolio manager of the Fidelity global technology fund, does not disagree that valuations in some parts of the tech market are looking extremely expensive but that does not mean all tech shares are pricy and price can be somewhat relative in this area anyway. He notes that Google’s valuation was often considered too expensive. That said, Solomakhin does not believe that all the highly valued internet companies of today will be able to turn into a Google of tomorrow. “On a five to seven-year view, out of all of these expensive stocks, only one or two will make it.”

Benoit Flamant of Paris boutique IT Asset Management, which specialises in technology investments, notes Google today is a formidable’ growth engine, proven to be very resilient to economic downcycles. However, while the company’s earnings rose by 31 per cent in the difficult 2008 period, over the year to end of April, the stock is down by 8 per cent. Flamant attributes some of this to media reports the firm is investing to defend itself against internet sensation, Facebook. While the latter has yet to list, with more than 500 million subscribers, the company’s growth potential is already estimated to command a $60bn valuation. “In essence, Facebook is viewed as a strategic threat to Google to such an extent that Google is currently treated by investors as if it already has already reached the same maturity status in 13 years that took Microsoft 36 years to attain.”

Such is its maturity today, Google may now fall into what Solomakhin catagorises as value tech, with the internet search engine on a multiple of just 12.

One possible explanation for the recent, overwhelming popularity in internet stocks is their familiarity. In the late 1990s, companies that shot up in price were hardly known – investors were merely caught up with the idea. Today, few among us do not know the likes of twitter or Facebook. However, Solomakhin does not think name recognition will play a very big role in their eventual success or failure. Key will be their business models and the ability to monetise their offerings, he says.

Managers such as Solomakhin and Simon King, senior investment manager at Premier, feel the interest driving tech at present springs mostly from the current investment conditions. “In times of low growth and returns, investors overrate growth and chase sex and violence,” says King. Despite this sentiment, neither manager is dismissive of the opportunities that tech may hold right now. King says investors need a reality check on the level of revenues an internet business can generate but he also feels social network sites may well benefit from recession as they can tap into the desire by those made redundant to network.

As to whether the recent moves spell the start of the next bubble, Solomakhin is sceptical, noting there are some keen differences this time round. In the late 1990s, all technology-related stocks were rising rapidly, he said. Today, extreme valuations are only present in a few hot areas while much of the tech sector remains closer to eight-15 multiples. “I still see more value stories than momentum in this market,” he says. “In 1998, it would have been difficult to find any value tech names.”

Other tech managers agree there are substantial reasons to like this sector right now, such as a recovery in capex expenditure on IT systems with the drivers of sub-sectors like semiconductors very different from those influencing internet firms. In fact, in looking across the top 10 holdings of the eight actively managed tech funds in the IMA sector, most are invested in large-cap names.

Solomakhin says he associates more with the middle to value end of the tech spectrum. Of the eight funds, six hold Apple, six also hold mobile phone technologies group Qualcomm. In addition, four feature Oracle in their top 10 just as four of the funds hold Google, while three feature Microsoft.

Technology is a touchy subject with many people, particularly those who got burnt at the turn of the century. However, the glamorous appeal of these firms makes it easy for investors to forget.

The idea of making easy money from the next big story is always hard to escape in investing, even more so in an area like the internet, which many feel they understand.

Advisers are likely to have their hands full in the coming months holding back client enthusiasm for this area.

Making it easier at the moment is the fact that many fund managers, tech and generalists alike, seem rather circumspect about the recent activity in this space. There is no talk of new paradigms or new economies – just yet.


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