Investors tend to have long memories, especially when something happens that severely damages their portfolios. Which is why they have tended to shun the small band of funds that specialise in the technology sector since its dramatic fall from grace in 2000.

Alan Torry, one of the most experienced managers in the sector and who runs the SG Technology fund, observes that ‘The fundamentals of the technology sector are still being ignored. It is staggering how much pain continues to be felt from post-2000. The ten-year performance figures are still appalling, and that is where people’s memories are.’

Bad memories
The charts bear this out. Over five years, technology funds have performed reasonably well. Despite quite a dramatic sell-off since the turn of the year, the IMA Technology & Telecoms sector is up over 44 per cent during the period. However, this is still some way below the capital return for the FTSE All Share Technology Index, at just under 58 per cent, and the total return for the same index, 68.89 per cent.

Go back to the end of April 1999 (the earliest date for the FTSE All Share Technology Index), however, and the picture changes dramatically, with a rise of nearly 200 per cent in less than a year – to the peak of the tech bubble in March 2000 – and then an even more severe plunge from September 2000, so that the index remains more than 75 per cent lower than its starting point. The average for the IMA Technology & Telecoms sector, by comparison, is only just over 32 per cent down.

A bull market in tech
So anybody investing in tech five years ago would have pretty much got in at the bottom of the market and made a respectable return. But very few private investors did so, scared off by the horrors of the preceding 24 months.

Ben Rogoff, manager of Polar Capital Technology, argues that ‘The frustrating thing is that we haven’t really participated in the last boom, because there has been limited capital expenditure on tech. Capex is roughly only 50 per cent of where you would expect it to be, so you have tech companies with the best balance sheets in the market and relatively subdued fundamentals.

‘Technology had quite a good year in 2007, because investors thought it was insulated against domestic weakness, in addition to which dollar weakness makes buying US technology companies very cheap. As a result, people were very overweight the sector going into the end of last year.’

But he adds, ‘Since the turn of the year, generalists have been dumping tech as its safe haven status has been called into question. It is a combination of rotating out of tech because it had a good year last year and generalist fund managers remembering that, when things turn down, tech is the first thing to get rid of.’

A select band
There are currently a dozen UK-authorised open-ended funds specialising in the tech sector, and a further two closed-ended investment companies. In general terms, their performance reflects that of the indices – pretty respectable over five years to
the end of March 2008, deeply disappointing over ten years.

However, the first quarter of 2008 has seen tech stocks fall back again. Walter Price, manager of the closed-ended RCM Technology Trust, admits that ‘We cannot ignore the economic environment we are in and the fact that the full impact of last year’s liquidity crisis may not yet have been felt. As a result, we are likely to see company IT budgets for 2008 under close scrutiny and, in many cases, cut.’

But he adds, ‘In these more difficult times, investors have historically favoured companies capable of maintaining sales growth through product innovation. Corporate activity could also increase further, as seen in Oracle’s purchase of BEA and Microsoft’s bid for Yahoo.’

Ben Rogoff feels that ‘Mobile compatibility is the future of computing. Microsoft will be the biggest loser from this process and that is why they tried to buy Yahoo. Microsoft is a business that is already operating at its optimal level. Companies in this situation can’t develop into new areas themselves because this would impact massively on their P&Ls.’

An international perspective
Indeed, this illustrates another significant factor with regard to the performance charts. During the recovery over the past five years, the IMA sector average has lagged behind the FTSE All Share sector index, but over the longer period it has outperformed it significantly.

This reflects two key features of these funds. They operate across a broader range of companies, for example including telecoms companies as well as ‘pure’ tech stocks and, whereas the FTSE index is made up entirely of UK-listed companies, most tech funds have international portfolios, usually with the bulk weighting towards US tech companies.

Alan Torry observes that ‘If the US market is going to pick up, tech will be part of that, but if it goes into recession, investors are going to want to avoid tech stocks.’

However, he adds ‘Having said that, what is happening in the US is becoming less important, as Europe and the Far East are becoming more important. The US is still an important location in terms of where companies are based, but it is nowhere hear as large as it was in terms of where the technology is actually being used. For example, there are more mobile phones in the developing world than in the developed world, and the developing world is seeing a rapid expansion in PC use.’

Security in large caps
Another key difference with the profile of the sector at the time of ‘the bubble’ is that it is much more diverse, encompassing global giants like Microsoft alongside small, one-product software development businesses. The natural instinct of tech fund managers is to seek out the small, growth stocks, but under current circumstances a more prudent approach is called for.

Ben Rogoff admits, ‘I am not a great fan of larger-cap tech stocks, but, at the moment, they look a pretty good way to weather the storm. If you are worried about credit problems, then this is a good place to be. Large-cap tech companies are the only group of companies with net cash on their balance sheets. Their customers may be under the cosh, but the large-cap tech stocks themselves have never looked better.
‘Over time, however, you will see our trust rotate back to more like its traditional profile of 30 per cent large-cap, 40 per cent mid-cap and 30 per cent small-cap.’

Walter Price agrees. He points out that ‘In May 2007, the trust’s portfolio was rebalanced to reflect RCM’s views of markets, trends and opportunities. This resulted in a significantly higher weighting towards larger-capitalisation securities and a reduced allocation to the UK and Europe.’

Alan Torry asserts, ‘One really positive theme in the next recovery cycle will be that the emerging markets will become really big buyers of technology. In the same way that they have dominated demand for primary goods in this cycle, they could do the same for technology in the next cycle.’

Time to buy?
So is it a buying opportunity? Alan Torry reports that ‘Some of the sentiment readings we are getting are close to 2000 levels and earnings are being revised downwards in a similar way, suggesting that sentiment is as bad now as it was then. It is against all intuitive sentiment, but that is exactly the time that you should be looking at this market.’
And Ben Rogoff insists, ‘There are brief periods where you get the chance to buy tech at around the market multiple, and this is one of them. Relative price-to-earnings ratios have contracted from 1.3 times the market to 1.2 times.’

He concludes, ‘We will have to endure a nasty results season for the first quarter of this year, but the plan is to use the cash in the funds to buy on weakness. But I do think earnings will prove to be more robust in the second half of 2008.’