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Tough times for technology

Technology stocks look set for a rocky 12 months although value can be found in specific companies, fund managers claim.

Investment houses are bracing themselves for a tough time in the tech sector but claim that specific stocks can still yield value.

The past year has been a rollercoaster for technology firms with a late to mid-year bounce pushing up stock and sector prices by around 30 per cent.

This followed an early year bull run that was followed by an equally dramatic turn around in prices as investors, wary of the 1990s tech boom, looked to reap the profits and tried to predict that prices had hit a high.

For many fund managers the problem with technology stocks comes with valuations, or to be precise, over-valuations. Overconfidence in the performance leads to many firms being overpriced and hence unattractive.

For many, it depends on what technology is classified as. Fund managers complain that IFAs and consumers often dilute the term to the extent that it has become a catch-all for any business vaguely involved in anything electronic, though the argument from investors is that fund managers will bolster their portfolios with burgeoning internet firms, phone companies, IT service providers, and media companies.

Realistically, says Legg Mason Investors fund manager Jeremy Knight, there is no point in looking at sectors since value is stock-specific. His European fund has been overweight in tech stocks for over a year and this is down to stock-specific reasons.

Knight says: “It is quite hard to generalise within this investment space. There are some firms that look overvalued and some that look undervalued, you just have to look at the individual business.

“From our point of view, when you get inside the company there are many stocks that we find are on very reasonable valuations. They have good business models and are very sound indeed.”

It is as much about finding the stocks that won’t do well as it is those that will. He points to service providers like Logica and Cap Gemini that, while showing a recovery in profits, actually show no signs of picking up new business.

And there could be tough times ahead for mobile phone companies like Nokia and Eriksson as the mobile phone handset market looks to reach saturation point and the final evolution of third generation phones still in the offing.

Stocks like ebay, Google, Yahoo and Amazon have a combined value in the US of $231bn. This had the Wall Street Journal recently proclaiming that a second “Internet Boom is Under Way”.

In turn Dresdner Kleinwort Wasserstein head of global equity James Montier points out that just because the market has risen does not mean a boom in back. He says that no investor with any concept of valuations would step near these firms because the average price to earnings ratio across the four stocks was 121 times, while price to sales was 15 times.

Perhaps evaluations of price to earnings is where the real value lies, and not in price to sales, says Montier.

He remembers an equation done by the chief executive of Sun Microsystems which had a price to sales ratio of 10 times revenue when the stock was at $64. This meant that to give a 10-year payback, the firm would have to pay 100 per cent of revenues for 10 straight years in dividends. It assumes the firm had zero cost of goods sold, zero expenses, paid no taxes, and no taxes on dividends, and had zero research and development. As any chief exec of a tech firm will point out these are respectively improbable, impossible, nice but unlikely, illegal, and commercially suicide.

So how can a fund manager find his value when the signals from the market are so hard to read?Morley UK smaller companies fund manager Robin West thinks that the tech sector is pretty cyclical and hence stock selection is paramount.

He is looking for firms that have got finance directors looking to loosen the purse strings so that investment in research and development can lead to company growth. This is because in the past there had been considerable overspending in tech firms.

A key stock for the smaller companies fund is Aveva group, which provides 2D and 3D visualisation systems for commodities companies.

West says: “What makes them attractive, aside from being a good sound business, is the crossover that they have into these other sectors. Their main companies are power, oil, gas, chemical companies and this is a real growth area at the moment.”

Meanwhile, New Star UK alpha fund manager Tim Steer has found growth in defence technology stocks, and has just increased his exposure to them.

He has taken on firms such as Meggitt, Ultra Electronics and Detica, all of whom have benefited from the Govern-ment’s current focus on modern defence systems.

There are few who are prepared to gamble on the tech sector as a whole the value of individual stocks is where alpha can be found.

The Morley TMT fund holds just 30 per cent of its portfolio in technology stocks, about half in telecom and 20 per cent in media. Manager Knight thinks that medium-sized companies are where the value in the sector are to be found.

He says: “Larger firms tend to be where there are overvalued stocks and this is because everyone is looking at them. They tend to be over-owned.

“But if you drop down to small and mid caps then this is where tech companies can come into their own.”

Understandably managers with strong reputations for stock picking remain confident. But the market remains volatile. It is only when consistent alpha returns to tech stocks that investors will feel the same eagerness to put their money back in the sector.


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