Anyone invested in shares in the technology sector in the past ten years has lived through a period of turbulence, with many ups and downs. A lot of investors only remember the painful experience of seeing the technology bubble burst. From the high point in March 2000 to the low in autumn 2002, the technology market lost a full 80% of its value. Now more than half a decade later, and particularly after the sharp correction in the opening months of 2008, it is time to review the situation in the high-tech sector.

 

 

Technology companies earned record profits in 2007, and they have solid balance sheets. Due to good profitability and the conservative investment policy of companies in the sector, the technology industry is the only sector without net indebtedness.

 

And what about the valuation? Numerous companies such as IBM, Hewlett-Packard or Nokia are showing a return on cash flow after capital expenditures in excess of 7%, an extremely interesting valuation compared with the returns on US or German bonds of less than 4%. Even so, the Nasdaq is still at just half its level in 2000.

 

In recent years it has become clear that the IT sector still has growth potential, but is subject to cycles in corporate investment. In the USA, the IT sector accounts for half of all investment (excluding real estate). It is pretty clear that the growth curve has to level out.

 

 

There are two primary conclusions to be drawn from the above information. First, this sector will produce some winners but also some losers, as was the case in the boom of the 1990s. Second, the IT sector will continue to advance into neighboring areas, thanks to the advantages that the IT era has brought in terms of speed.

 

Two examples of such interaction are biology and energy research. Biochips are a completely new area. Now that the genome has been fully identified, innovative applications with processors are possible that will quickly calculate the data for complex tests. The process technology know-how gained over the years can then be used to cut costs and make the technology accessible to the mass market.

 

The second example is the solar industry, which is growing a near-explosive rate. One reason for this is that some costs can be cut using exactly the same techniques which have proved successful in the semiconductor industry. It is accordingly not surprising that the major US chip producer Applied Materials bought a Swiss solar industry supplier in 2007 for a high price, and that Intel and Samsung are also considering entering this field. The cost savings that mass production brought to the technology industry will help the solar industry achieve grid parity (i.e. the same price for solar energy and conventionally generated electricity) in the not-so-distant future.

 

 

Looking at product cycles that are affecting the technology sector, currently portable navigation devices that process data from GPS signals are conquering the market (see text box). Another product with growing demand is light-emitting diodes (LED), which have the advantage of using energy more efficiently, with a significantly longer lifetime than traditional bulbs. These diodes have been used for years in telephones, and are now being used in other areas, such as notebooks and TVs. Several countries (Canada, for example) have banned the use of incandescent bulbs after a transitional period of only a few years. This will mean enormous demand for white LEDs, and numerous technology companies are looking at soaring growth.

 

A more exotic example is 3-D printing, a new subsector which will grow into a multi-billion business. Did you ever want to see a small three-dimensional model of your new house? No problem. Using technology that is already available, standard architectural software and a special printer can produce a miniature copy of your dream house in colour in just a few hours. This opens up many new possibilities, such as for the automotive industry in designing new vehicles, to mention just one potential field of application. It is important, however, to remember that many new products fail. Investments only pay off if the innovators identify the right trends.

 

 

Thanks to innovation, the technology sector offers interesting long-term returns. For the investor, however, stock picking is the decisive factor. Buying a basket of a few blue chip technology shares like IBM or Microsoft can result in significant underperformance over time, compared with buying top-quality investment funds. This is due to the size of the companies, and the increasingly cyclical nature of their business. Active portfolio management of well-selected stocks in developing new markets offers better investment opportunities in the long term. The important thing is to use a solid approach based on fundamentals to identify the pearls.

 

Bolko Hohaus, LODH Infology Fund Manager