Institutional investors are underweight technology, but managers say the sector works well as a defensive play, finds Maha Khan Phillips
We appear to be entering a year of low growth and low inflation, and the euro-zone crisis, as well as deteriorating liquidity concerns, has led investors to look at defensive strategies and reduce exposure to growth and cyclical sectors - including technology. Despite this, managers say technology can be a good defensive play.
"To say that technology is a defensive play would probably have been offensive in the 1990s," says Bolko Hohaus, head of the technology team at Lombard Odier. "But at the moment, I think it's correct. You can see it in the market performance: the world's equity markets are down, but the MSCI IT index this year is outperforming by roughly 5%."
Technology stocks include both hardware and software, but growth is coming primarily from information technology and software, as well as communications technology. Global mobile-phone penetration should reach 85% by the end of 2011, up from 8% at the start of the century, according to research from Standard & Poor's.
Two trends are converging, the first is the adoption of mobile phones for voice communication and the second, for devices which access the internet. People are increasingly using mobile devices, such as smart phones and tablets, to access the internet on the move.
"Just as the idea of waiting until we get home or to the office to make a phone call now seems quaint, so is waiting until we are back at our PC to look up a website, respond to an e-mail, or update a social media profile," S&P notes.
"The key driver is our behaviour," Hohaus agrees. "Ten years ago if you left your house and forgot your money you would probably have returned, but you would not have cared if you had forgotten your phone. Now, if you forgot your phone you would probably go home and get it, because after two hours of not being reachable, your colleagues or family would probably be calling the police."
James Crawshaw, equity analyst at S&P Capital IQ and one of the authors of the report, points out that software is where there is the greatest M&A activity. He is overweight US tech, which he says is the most important and relevant market, although he has buy recommendations on European heavyweights such as Vodafone (which has cleaned up house, disposing of minority stakes in SFR, China Mobile, Softbank and Polkomtel) and Ericsson.
"Globally, we are overweight," he explains. "We think some technology companies will continue to grow even in a recession. They involve a lot of change, and they are bringing new business models. Facebook will be able to grow even in a recession because companies will want to advertise on Facebook, and will spend less on TV broadcasting or on newspapers or magazines."
For his part, Hohaus believes that the technological revolution has become so important it could prove to be as significant as the invention of the printing press. By the end of 2011 - less than two years after it was introduced - Apple will have sold more than $20bn-worth of iPads. "Growth prospects look good," he says. "There is a lot of innovation."
He also points to more triggers for change. Amazon, for instance, is entering the tablet market at roughly half the price of Apple - the leader with about 80% market share - making up for a 0% margin by creating additional revenue from content such as books and video. Business models include using content to lock in customers: once you have spent money on applications, you are less likely to switch platforms.
Technology would also be a good defensive play because other sectors are faring so badly in comparison. Jim Swanson, chief investment strategist at MFS Investments, points out that the world's usual defensive sectors are telecoms, healthcare, utilities, and staples. "But the world has changed. The healthcare sector is the number-one fiscal austerity target in most countries where it is heavily government-directed. Telecoms are changing, too, because they used to have repeatable flows that were pretty consistent because of landline phones. Young people now don't have landlines, so that consistency isn't there. As for utilities, the staples sector is dealing with tremendous commodity volatility."
S&P suggests that companies involved with social media and mobile technology should embrace their utility-like nature. At the moment, many internet services are provided free of charge or below cost, because companies are focused on subscriber acquisition. By becoming the dominant provider in a particular niche, (such as streaming music), companies are hoping to gain an economy of scale which will enable them to build a long-term defensible franchise. "Once the barriers to entry are raised, many of these companies will presumably start to increase the amount of advertising they carry and/or introduce or increase subscription fees, just as the websites of some newspapers do," says the report.
There are other issues that investors need to be aware of. As Natalie Tydeman, senior adviser at private equity media and communications specialist GMT Partners points out, the pace of technological change in the last century was very different compared to the last decade.
"When a device has received 50% penetration in any particular mass market, then you would consider that market as having reached saturation - and whether it was the radio, television, or colour television, you once had a major advance approximately once per decade," she explains, suggesting that investors should opt to put their money in a sector-focused fund, so that they have access to the level of expertise required. "But in the last 5-10 years there have been an enormous amount of devices that have reached 50% penetration. Whether it is social networking, mobile phones, or digital TV, the pace of innovation has massively accelerated over the past decade and will continue to do so. It's evolving rapidly and it is extremely complex. You need to understand what is going on in a great amount of detail."
For investors, technology holds one big plus. In a debt-laden world, the balance-sheet risk for the majority of technology companies is virtually zero. "This sector is awash in cash and has no net debt," says Swanson. "Also, there is more replacement of software and new types of software. Interestingly, in the US the average age of installed software is 5.3 years. That's the oldest ever. There is going to be a lot of deferred spending which is going to buoy the sector, whether or not markets are gyrating."
For its part, Lombard Odier points out that forward earnings multiples in technology are at the lower end of the range for the past 25 years, even though emerging markets are on the cusp of becoming the biggest internet user base globally. Many firms are generating free cash flows that could generate high single-digit or even double-digit returns, at a time when yields are low elsewhere.
Product innovations, such as the move towards Cloud technology, e-wallets, organic LED televisions, ‘Ultrabook' laptops with touch screens and instant-on memories, will also help move the sector forward, as will the growth of alternative payment systems which are part of the driving force of internet developments. Despite cyclical decline, there is every reason to be positive, say Tydeman.
"Technology growth is projected to be 5-6% over the next few years. That is the projected growth rate of Brazil," she argues. "If people can be excited about the BRIC countries then they can be excited about this as well."