Ten years on from dotcom-where now for the tech sector?

A full decade after the woes of the dotcom bubble, Polar Capital's Nick Evans and Ben Rogoff say a new cycle is emerging…

This month marks the 10th anniversary of the ‘dotcom bubble’ and by chance also the one-year anniversary of the recent market lows. Until the second half of last year, technology funds had been largely ignored for much of this decade by advisers and their clients, many of whom had an understandably jaundiced view of the sector. However, the technology sector significantly outperformed last year, the Dow Jones World Tech Index rising 60.2% in US dollar terms more than twice the price return achieved by the FTSE World Index.

This quantum of outperformance has begun to generate renewed interest in the sector once again, although after such a stellar year, some may feel they ‘missed the boat’. Our sense is that – unlike 2003, when the sector enjoyed a brief break from the de-rating process that culminated in 2008 – the past year will prove to be the beginning of a multi-year period of outperformance driven by the unfolding of a new technology cycle, aided by structural under-wnership and undemanding valuations.

Track records

Of course, it has been ‘easy’ for advisers to ignore a sector that has significantly atrophied since 2000, the UK IMA Technology universe having shrunk to just 10 funds, many of which lack the necessary scale and performance track records to justify the resources required to fully evaluate the sector. Fortunately, both the investment trust and offshore global technology peer groups offer a greater selection of specialist technology funds that boast sufficient size and performance profiles many of the oft-mentioned onshore funds cannot. The other dynamic contributing to the sector being overlooked has been the assumption technology exposure can be achieved via generalist portfolios – in essence, the argument technology is ‘just another sector’ and therefore does not justify a specialist product.

While this view appears to have been borne out during the past 10 years (as the sector worked off the excesses associated with the bubble), we strongly believe the new cycle will make plain the differing fortunes of legacy incumbents (usually large index constituents) and next-generation companies. While the former will have much to lose from a new disruptive cycle, the latter – unencumbered by turf to defend – should meaningfully outperform.

Driving earnings growth

We believe this dynamic remains poorly understood, perhaps because last year it was overwhelmed by cost-cutting efforts that proved just as effective as revenue as a driver of earnings growth. However, that is already changing in 2010; smaller-cap technology companies have begun to materially outperform, reflecting the fact a number of the incumbent companies are beginning to more fully look their age now these cost-cutting efforts are largely complete.

‘Financial engineering’

Without the ability to ‘financially engineer’ bottom-line growth, we expect many of these well-owned companies to struggle to deliver earnings growth substantially in excess of revenue growth going forward. In stark contrast, there are a myriad of next-generation companies that have managed to grow revenues during the recent downturn, many with exposure to our core portfolio themes – cloud computing, mobility and broadband applications.

The phenomenal success of the Apple iPhone (and the app store with more than 140,000 applications and three billion downloads so far) relative to the associated pain experienced by Nokia and other incumbents highlights the significance of this effect – and that fails to account for the huge impact this is likely to have on mobile operators whose networks are struggling to cope with the huge volume of associated data traffic driving surging IP-based equipment demand. Given this polarisation of fortunes, a mainstream approach is likely to underwhelm. Instead, we believe investors need to adopt a stockpicking, small- and mid-cap-centric approach in order to capture the uneven value creation associated with a new cycle.

The importance of generating cash

While the sector has found it hard to shake off the painful memories of the bursting of the ‘bubble’, technology companies have done a lot of ‘growing up’ during the past 10 years. Management teams that survived have learned critical lessons such as the importance of generating cash, which served them well during the recent credit crisis. Today, the sector remains one of the least challenged by the ongoing deleveraging given its strong collective balance sheet, low pension liabilities and superior growth potential.

While we expect revenue growth to prove a key determinant of relative returns going forward, headline valuations remain undemanding, with the technology sector trading at just 1.1x the market P/E. Not only is this significantly below both the 10-year ex-bubble average of 1.3x and the (nonsensical) peak level of 3x achieved in 1999-2000, but once excess cash is considered, we believe the sector trades at close to a market multiple despite having sharply outperformed since late 2008.

In addition, 10 years ago the sector was at the centre of not only a financial bubble but a capital investment bubble, the resulting overcapacity taking many years to work off. This time around, the sector is coming off a prolonged period of under-investment, resulting in current supply side constraints and likely to lead to an improved pricing environment.

Tailwinds

Near term, we expect the secular growth potential of the sector to be augmented by cyclical tailwinds. The improving economic outlook, an ageing installed base of personal computers and significant product upgrades (including Windows 7.0) are likely to drive an enterprise-refresh cycle in 2010. Longer term, we believe the PC sector faces some formidable challenges as technologies such as desktop virtualisation and thin clients gain traction. We are already beginning to see a major shift in this direction with several leading investment banks embracing ‘virtualised environments’ this year, but in the meantime, we expect PC and component stocks to benefit from a textbook-like cyclical boost.

However, once this dynamic has played out, we expect investors to begin to more fully focus on the new cycle, its positives and negatives. Indeed IT buyers appear to be finally embracing it now – one of the most compelling articles we have read recently being the Gartner chief investment officer (CIO) survey, which demonstrated a significant shift in spending intentions, the top six priorities for 2010 being virtualisation, cloud computing, Web 2.0, networking, business intelligence, mobile technologies and data management and storage.

Priority shifts

While enterprise applications had been ranked second for the last three years, this fell to 13. This highlights a marked shift in priorities away from legacy infrastructure towards new technologies that form the basis of a new cycle, characterised by the recentralisation of computing (described as ‘cloud computing’) but better understood as a step on the path towards delivering IT as service, or ‘utility computing’.

This cycle is likely to be the most significant since the rise of the desktop computer in the 1990s and yet it garners limited coverage, and it remains poorly understood. It will likely frustrate the ongoing efforts of slower-growth incumbents to financially engineer earnings growth ahead of organic revenue growth.

As such, we  expect this group of companies will either step up spending and/or M&A activity over the coming year as they “invest for growth”, which is better understood as needing to replace business lost forever to disruptive technology, increased competition and lower prices associated with a new technology cycle.

It is not as if large-cap technology companies are short of firepower – Google, Apple, Microsoft, Qualcomm and Cisco combined have more than $130bn of net cash on their combined balance sheets. After years in purgatory, the sector boasts many of the key ingredients – strong balance sheets, undemanding valuations and a new cycle – that auger well for the coming years against the likely backdrop of sub-trend global growth. 

Nick Evans and Ben Rogoff are managers at Polar Capital

This article first appeared in Investment Week.