Spotlight on technology

Tim Cook, the chief executive of Apple, probably had a fair idea that the role was a poisoned chalice when he inherited it following the death of Steve Jobs in 2011. Not only was there the impossibility of following Jobs, but also, Apple had become the biggest company in the world in a sector where investors are fickle and fortunes change almost overnight. The stage was set for a fall from grace.

So it has proved. Money Observer warned in the August 2012 issue that Apple’s star was about to wane on the grounds that the company ‘has to run just to stand still’. Since then, the company’s inability to do exactly that has seen its share price fall by around a third. More aggressive competition from rivals such as Samsung and Apple’s own failure to unveil yet another blockbuster product culminated in its first quarterly fall in profits for more than a decade during the first three months of 2013.

It is a cautionary tale. The technology sector is more prone than any other to bubbles, as investors rush into the latest big thing. Apple remains hugely profitable, innovative and well-placed in terms of market share, but its valuation in 2011 and particularly in 2012 was out of proportion to its actual trading performance. Any setback, however minor, was therefore likely to prompt a very rapid sell-off of the stock.

This characteristic of the sector adds an additional element of risk to picking technology stocks. There is a decision to make at the outset: do you seek to ride bubbles, confident in your own ability to get out before the herd, or do you aim for longer-term growth stocks where the immediate returns may be less exciting?

The solution may be the middle path: to seek out the themes likely to dominate in technology over the months and years ahead – and then to buy and hold the companies that will benefit from them without getting caught up in short-term volatility.

This approach can pay off handsomely, even where a bubble pops. Had you bought Apple in June 2007, when the iPhone was first launched, as a bet on the trend towards greater smartphone use, you would still be sitting on a three-fold profit today. Had you bought the stock in April 2010, when the iPad came out, as a bet on the rise of the tablet, you’d still have roughly doubled your money. 

Moreover, at times such as now, when money is short, it’s even more important to back only those businesses that have the best ideas: they’re the ones that will be prioritised as resources are allocated. That’s true in the consumer technology sector, where disposable incomes remain depressed in many of the world’s leading economies. It’s also true for corporate IT purchasing: technology executives at most businesses are still being asked to do more with less.

Despite the straitened times, analysts at the market research company Gartner still expect global IT spending to rise this year and next. They put global IT spending at $3.62 trillion (£2.33 trillion) in 2012, but expect it to rise 4.1 per cent to $3.78 trillion in 2013. Next year’s forecast is for a further 4 per cent increase, to $3.93 trillion.

That sounds promising. But spending growth at these levels will not meet everyone’s needs. Technology analyst IDC says the ‘digital universe’ – all electronically stored data – is now doubling in size every two years. It thinks internet traffic will average 29 per cent annual growth over the five years to 2016.

The sweet spot for investors may therefore lie in the technologies that can bridge the gap between people’s computing needs and desires, and their ability to finance them. To put that another way, expect new technologies to mop up all the new spending in the sector – and more – at the expense of those that are more established. Businesses that don’t have the former will suffer as sales of the latter are eroded.

Significantly, some of those technologies have already achieved critical mass. Cloud-based computing and tablet devices, for example, are now at penetration levels where mass adoption is likely. Businesses in such areas can benefit in two ways – either from a surge in demand for their products, or because established companies with older technologies now at threat of disruption, seek to buy their way into the new markets with merger and acquisition programmes.

‘We believe that the new technology cycle is likely to enter a more disruptive phase as the growth in each of our core themes increasingly comes at the expense of incumbent technologies and vendors,’ says Ben Rogoff, the manager of the highly-rated Polar Capital Technology investment trust. ‘This is entirely consistent with previous periods of economic uncertainty that have been associated with rapid adoption of new technologies.’

Those ‘core themes’ include cloud computing, which is rapidly becoming the favoured architecture of business of all sizes around the world – as well as public sector organisations such as the US government, which last year adopted a ‘cloud first policy’. This is a broad sub-sector, encompassing everything from providers of cloud-based applications to data storage centres to small companies selling back-up services to consumers.

Allied to the growth of cloud computing is the software-as-a-service (SaaS) industry, which sees developers supply software online to users. Users no longer need to buy such software outright – they rent the service as and when it is needed – and applications can be continuously developed and improved.

Investors such as Rogoff also expect to see a continuation of the technology trend dubbed ‘ubiquity’ – the idea that people can use technology, including online services, whenever and wherever they want. This trend is fuelled by the continuing boom in sales of tablet devices and smartphones.

Often, these themes coalesce – so, for example, the combination of cloud computing and smartphone growth has boosted social networks, helped the online advertising market and created storage and content synchronisation opportunities.

However, there will also be losers from these trends. For example, in 2012, combined sales of desktop, laptop and notebook PCs were eclipsed for the first time by sales of smartphone and tablet devices. The PC market is still growing, but only because emerging markets are still buying. Elsewhere, including in the US, sales have begun to decline.

Similarly, as the shift towards the cloud and SaaS continues, the prospects for old-style software businesses and IT services companies look gloomy. Business customers, in particular, will rent software as and when they need it, and they won’t maintain complicated legacy IT systems that require constant attention. In the consumer market, as individuals do more on tablet and mobile devices, they will no longer need all of the kit associated with a desktop PC, from software to virus protection. 

As these trends play out, the challenge for investors will be to find the winners and losers (see the box above), but valuation is important too in a sector where it is easy to overpay for strong companies.

The good news on valuations, however, is that they currently look reasonable, particularly given the sizeable amounts of cash many technology companies, especially in the US, are maintaining on their balance sheets. On both sides of the Atlantic technology businesses are generally trading at below their typical historic multiples. ‘With low valuations and growing yields, many tech stocks have good support,’ says Walter Price, manager of the RCM Technology trust.

Winners and losers in the technology sector

Winners

Arm Holdings

Arm shares are already trading at 40 times forward earnings, so this is hardly a bargain-basement selection. Nonetheless, with an increasing presence in the server sector and a position as the world’s pre-eminent designer of chips for tablet devices, Arm’s long-term future is super-bright.

Aveva Group

Specialising in plant design for industries such as oil and gas, engineering software manufacturer Aveva has won plaudits for its products ever since it was spun out of Cambridge University in 1968. Now it is moving towards the software-as-a-service model.

Wolfson Microelectronics

Wolfson is less well-known than chip designers such as Arm Holdings and Imagination Technologies, but it is another British success story. A deal this year to supply Samsung with audio chips prompted another rash of buy recommendations from technology analysts.

Losers 

Apple

Notwithstanding the calamitous share price fall since October of last year, Apple stock still looks decidedly overvalued. The company has no major product launches in the pipeline this side of Christmas and its rivals look ever-stronger. Further sell-offs of the shares look inevitable. 

Hewlett Packard

Predictions of the demise of the PC market may be premature, but this is an industry in decline and companies such as HP and Dell will suffer accordingly. Plus HP is still trying to deal with the fall-out from its purchase of Autonomy, which looks years away from producing happy results. 

Spirent Communications 

Spirent is one of very few quoted technology companies in the UK that investors would currently put into the disappointing category. A global slowdown in investments in telecoms networks has hit Spirent, whose products are used to test network reliability, and there is no immediate prospect of an uplift.

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