One of the best strategies when running a trust portfolio is to focus on those sectors where sentiment trails fundamentals - particularly when this is reflected in good quality trusts standing on unduly wide discounts. When market sentiment does catch up with reality, investors benefit both from a rising net asset value (NAV) and the trust discount narrowing. And this is before you take into account the benefit of any gearing which will enhance the NAV returns. Such opportunities exist in the technology sector right now.
The case for technology
Sector sentiment has been poor for a number of years. Seasoned investors will remember the dot-com crash which ushered in the 21st Century. The markets chased valuations forever upwards, in the hope that these wonder stocks would produce untold riches - despite the fact many had yet to produce a profit and some even a revenue stream. This could not last, and didn't.
Many investors got burnt as a result. The episode cast a long shadow. Meanwhile, recent economic uncertainty and investors' preference for defensive and less cyclical strategies has not helped. Add in some disappointing news from a few high-profile technology stocks such as Apple, and it is not difficult to see why sentiment has remained depressed.
But both the market backdrop and sector fundamentals are improving. As equity markets continue to respond positively to government efforts to tackle the global economic challenges, investors will rebalance their strategies away from defensives and towards the more cyclical sectors. Without getting carried away, to use the unfortunate terminology of the day, we are now in 'risk-on' mode.
But, more importantly, the sector itself is in rude health and prospects continue to look good. Technology companies, particularly in the US, have started to benefit from a big increase in investment spending after a period of severe underinvestment in recent years. US corporations have lots of cash on their balance sheets and need to play catch-up.
Furthermore, there are numerous secular growth trends to exploit, including cloud computing, smart phone applications and the e-commerce market.
For example, global e-commerce sales reached $1 trillion last year and are set to expand a further 30 per cent this year. Robust growth is forecast for years to come. Just 40 per cent of over-65s in the US are online compared with over 90 per cent for younger generations. Significant opportunities will be thrown up as this younger generation ages and grows in affluence. Those companies correctly positioned to benefit from these business trends will become stock market darlings. One could cite many more such secular trends.
It is little surprise then that, in recent years, most technology sub-sectors have outperformed the market when it comes to free cash flow, earnings and sales growth. Indeed, technology has the highest free cash flow yield of any of the major market sectors, and so balance sheets are awash with cash. No wonder the sector is enjoying good dividend increases. The fundamentals are good and improving.
And yet these good growth opportunities can be accessed at attractive valuations because sentiment remains depressed - it has yet to catch up with the improving fundamentals. Technology stocks are trading at close to their cheapest level for decades. The sector is on a price/earnings ratio of 13-13.5 times compared with a long-term average of 17-17.5 times. Low valuations, combined with rising dividend yields and profits, present great opportunities for the patient investor.
The next secular bull market in technology is upon us, but this time it is based on sound prospects.
Portfolio changes
With this in mind, I have introduced RCM Technology Trust (RTT) to both portfolios. The growth portfolio already holds Herald Trust (HRI), which is more focused on the technology sector in the UK, but the income portfolio has steered clear of the sector in large part due to yield constraints. However, given the attractiveness of the sector, I have introduced RTT to both.
RCM technology is an Allianz-managed trust run out of San Francisco by Walter Price, who has over 40 years' experience as a fund manager. The trust focuses on mostly mid- and small-cap stocks with more than 80 per cent of the portfolio invested in the US - mostly in Silicon Valley, the innovation nerve centre when it comes to US technology. The Far East and Pacific make up the next largest weighting at just under 15 per cent.
The strategy is to focus on growth companies - dividends are of secondary importance. Thankfully, Mr Price does not hug his benchmark (the Dow Jones World Technology index) - passive fund management can only underperform. Strong recent NAV performance added to a good longer-term record has propelled RTT to the top of its peer group and yet it still trades on an 11 per cent discount. This is an excellent entry point and investors should capitalise.
To help fund the introduction of RTT, I have made a few changes in both portfolios. I have reduced or sold entirely Scottish Oriental Companies Trust (SST). It has had an excellent run. However, this was a strategic decision borne out of the fact that, having started to significantly introduce Japanese exposure in December, I am continuing to balance both portfolios' exposure to the region in general. History suggests that a more competitive Japan will have knock-on effects for other economies, but I very much remain wedded to the region as a whole as weightings testify.
Speaking of Japan, I have also finessed my exposure in the growth portfolio. After a very strong run this year during which the yen has depreciated, I have sold entirely the iShares Japan £ hedged ETF (IJPH). Predicting currency movements is difficult and not something I tend to do, but we have managed to get this right for reasons given in my column 'Japan: A once in a lifetime opportunity?' (7 February 2013).
I have used some of the proceeds to introduce Baillie Gifford Shin Nippon Trust (BGS), which focuses on Japan's smaller companies - these are looking attractive relative to their larger peers. My thinking here is that, as the pace of economic growth picks up, smaller companies should do well from a relatively low base. Despite trading close to NAV when bought, BGS’s excellent track record warrants its inclusion.
Finally, I have introduced JPMorgan Mid Cap trust (JMF) to both portfolios. An excellent track record, decent discount and slowly improving economy, which should benefit FTSE 250 companies in particular, all merit support. It also carries a 2.5 per cent yield.
My next few columns will continue to focus on the theme of undervalued sectors.
View John Baron's updated Investment Trust Portfolio.
