Henderson's Stuart O’Gorman on whether the resurgence in corporate interest in technology spending marks an opportunity for technology investors
Ever since the collapse of the dotcom bubble in 2000, technology has been a dirty word for many investors, with the number of specialist technology funds dwindling as investors deserted the sector. It was not just investors who were disappointed by technology, but also all those who spent billions on the internet wave only to see their dreams dashed upon the rocks as companies failed to deliver on over-hyped promises.
However, change seems to be afoot in corporations’ attitudes to technology spending. The revenue growth of technology companies is rapidly outpacing that of the old economy as reality catches up with the hype. Could the resurgence in corporate interest in technology spending also mark an opportunity for technology investors?
Moore’s Law
Every year, technology seems to penetrate a little more into our lives. To understand how technology devices have gone from a luxury to almost a necessity it is useful to review one of the key long-term drivers of technology.
Gordon Moore was one of the founders of Intel and it was he who first suggested the semiconductor could halve in size, halve in cost or double in speed every 18-24 months. This rule of thumb came to be known as Moore’s Law and has held since the 1960s. This has two major impacts. First, new products become technologically possible, often creating entirely new business models – e-Books and Apps Stores being two recent examples.
Second, and possibly more important, is the fact that existing product prices can be reduced. Every year the functionality of most technology devices increases and prices either fall or stay the same. Therefore Moore’s Law means just that – more value for money and a corresponding growth in share for technology in the economy.
This has certainly been the case with corporate expenditure on technology, which has gradually risen as a percentage of gross domestic product (GDP) over time. However, this spending is volatile. Just as investors have demonstrated exuberance surrounding the potential of Moore’s Law, so too have corporate customers of technology. We all remember the days of the tech bubble, when any mention of “e-enabling” your business guaranteed project sign-off.
After the depressing results of spending on hype rather than reality technology budgets were viciously suppressed in the noughties. We believe this volatility presents investors with an opportunity using this chart and a very simple rule: buy when spending is below the long-term trend and sell when it goes above trend for any sustained period of time.
As the chart below illustrates this rule would have kept you invested in the technology sector during the 1960s and 1970s when Silicon Valley was being built. It would have got you out of the technology sector during the mid 1980s tech bubble and then back in during the early 1990s, pulling you out in late 1997 and avoiding the eventual pain of the dotcom crash. Finally, it would have triggered a buy signal about five years ago, since when technology has outperformed most other global sectors.
Blue-sky business
We are starting to see the early signs of a return of corporate demand for technology products. Earnings reports from technology bellwethers such as Cisco Systems have been strong, with order pipelines suggesting even greater strength in the future. Many companies have technology infrastructure that is so old this spending is not driven by the “blue sky, revolutionise your business” mentality of the technology bubble but by simple economics. Old technology products tend to break down and inflict ever higher costs on businesses to keep creaking PCs, servers and routers going.
In addition, the electricity bill for running a company’s information technology (IT) infrastructure is a major burden. Again, newer technology products, enabled by Moore’s Law, are much less power hungry than their older siblings. A dramatic example of this is the cost saving achievable by upgrading a data-centre.
According to a study by UBS, the ensuing reduction in electricity, real estate and IT staff costs pay for the upgrade in as little as five months. There are numerous other examples of quick paybacks from technology spending and as long as credit markets remain even vaguely accessible we believe this spending can only accelerate.
What is more, much of the increased revenue among technology companies is dropping straight down to the bottom line. Research by the Financial Times noted the top 10 technology companies have added $65bn to their reserves since the depths of the slump in spring 2009.
Apple alone has amassed nearly $42bn in cash and investments. Most large technology companies seem content to tack on smaller groups rather than engage in the mega deals seen in other sectors. Where merger and acquisition activity is taking place it appears to be more focused on eliminating competition, such as Cisco’s purchase of Tandberg, the Norwegian video-conferencing company, effectively turning the video conferencing market into a duopoly.
This strong cash-generation coupled with a cautious approach to mergers and acquisitions has implications for investors in the technology sector, particularly given the sector’s relatively low debt levels and preference for strong balance sheets. First, it means that technology’s perception as a relatively high risk sector among equities appears ill-deserved. Unlike finance or retail where volatile earnings and weak balance sheets proved a toxic mix during the credit crisis, the technology sector has escaped relatively unscathed, with several leading technology companies going on to record higher share prices in recent months than existed before 2007.
Second, the cash build-up is likely to put increasing pressure on company boards to return cash to investors through share buy-backs or special dividends. A nice problem to have!
Technology stocks may have performed well but they remain far from expensive. The cautious approach of boards means that valuations have yet to be bid up by corporate activity.
Technology stocks trade at approximately a 10% premium to the world market. This seems a meagre premium for a sector that offers companies with little or no debt, high cash generation and potentially a multi-year upgrade cycle by the corporate world.
Stuart O’Gorman is co-manager of the Henderson Global Technology fund and Henderson Technology Unit Trust
