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Tech it or leave it

Created:

23 June 2007

Written by:

Richard Anderson

To contrarian invest-ors, bad news is often good news. And when some of the UK's most successful fund managers, such as Neil Woodford and Anthony Bolton, can be counted as contrarians, then this seemingly warped interpretation of events is worth recognising, at the very least.

What, then, would a contrarian make of news that Aegon Technology, one of the oldest remaining technology funds, will close in July? There seem to be plenty more grounds for pessimism in the sector - this closure is the latest in a long line that will see the number of specialist technology and telecoms funds reduced to 14 from 28 in 2000. More will likely follow: Aegon has just £8.5m under management, but Investec Global Technology, Lincoln Internet Tollkeeper and Old Mutual Global Technology all have less than £3.5m in their portfolios, according to Morningstar.

The fixed costs involved in running fund portfolios are such that it's surely only a matter of time before these fund managers follow Aegon in announcing that their funds too are "not worthy of continuing". And it's not just these funds that are proving unpopular - almost all technology funds have suffered outflows of cash in the past 12 months. The reasons for this are simple.

First, investors have not forgotten the trauma caused by technology stocks plummeting 90 per cent over the three years following the dot-com crash in 2000.

Second, technology companies have since performed poorly compared with the main market - in the past three years, while the FTSE All-Share has risen 73 per cent, the FTSE Technology index is up just 29 per cent.

Finally, because portfolios are so small and fixed costs relatively high, technology funds are some of the most expensive around, with the total expense ratios of some hitting 2.5 per cent.

Silver lining

Why on earth, then, you may well ask, would you want to invest in a technology fund? The answer, contrarian investors will tell you, is that things cannot get much worse, so now is the time to get in before any recovery starts in earnest. As Mick Gilligan, associate director of research at Killik & Co, says: "Fund closures are a good contrarian indicator of whether you should be invested in a sector or not."

Or as Mark Dampier, head of research at adviser Hargreaves Lansdown, puts it: "It's usually a good sign that the end of the pain is near." There are examples where this has been the case in the past. Numerous emerging market investment trusts wound up in 2002 just before the asset class embarked on a bull run that has seen it rise by more than 250 per cent.

And even the seemingly impregnable Merrill Lynch World Mining returned cash to investors at a price of 63p in 1999 - but is now trading at 568p.

Positive attractions

Mr Gilligan believes that technology stocks are "quite attractive at the moment". "We are nearing the point in the replacement cycle when companies are looking to upgrade their kit," he says.

Indeed, as Darius McDermott, managing director of adviser Chelsea Financial Services, explains: "Companies are making record profits and are cash-rich. They have yet to spend on infrastructure and technologies."

This is simply because companies have been busy paying off debt and returning cash to shareholders, argues Mr Gilligan: "Their reluctance to actually invest heavily in the business is largely a hangover from the bear market that began in 2000." It can only be a matter of time before this hangover clears.

The latest Merrill Lynch Fund Manager survey shows clearly that renewed investment is precisely what managers want to see at individual companies.

Another attraction of technology companies, says Mr Gilligan, is the fact that their earnings are strong and have increased a great deal faster than their share prices. As Ben Rogoff, manager of the Polar Capital Technology investment trust, puts it: "Quite simply, the earnings growth profile of technology companies is better than those in the wider market."

He is particularly enthused about the prospects for tech stocks: "About six months ago, we became very positive on the outlook for the sector and we believe that now really is the time. Tech stocks have been derated far enough relative to the market as a whole and valuations have not looked this good since the early 1990s, particularly in the mid- and small-cap arenas."

Fundamentals aside, however, what really excites Mr Rogoff is the fact that we are, he believes: "On the cusp of a new architectural wave. The last major cycle began in the mid 90s and revolved primarily around client servers and mini computers. Now we are looking at a new 15-year cycle that is all about internet technologies such as those developed by eBay and Google. We have so much bandwidth now that these technologies can be delivered much more cheaply.

"There will be no need for disks or memory sticks as all word processing will be done online and all your information will simply be stored on the internet. It is happening already with Google Applications. Another example is Joost, the company that developed Skype, which has also developed technology that allows you to download TV anytime, anywhere. All these technologies are driving down prices and this is driving proliferation."

Best of a bad bunch

Of course, as a dedicated technology fund manager, you may expect Mr Rogoff to wax lyrical about the prospects for his sector. But the explosion of new and cheap internet technologies, strong fundamentals and negative sentiment towards technology stocks do add up to an interesting investment case that you should, at the very least, investigate.

Mr Gilligan's favoured play is Herald Investment Trust (the one technology trust not listed by Morningstar in the table below). He cites two reasons. First, it is trading on an attractive discount of 13 per cent. Second, 24 UK and US stocks in its portfolio were the subject of takeover bids last year and, with ongoing merger and acquisition (M&A) activity, there is every chance that more of its investments will be targeted.

Partly as a result of these bids, the trust's price has risen 19 per cent in the past 12 months. Its longer-term track record is also impressive, with a 60 per cent price rise in the past five years. Mr Gilligan like Polar, too, which has produced consistent outperformance relative to the index and is trading on a discount of 6 per cent.

Mr McDermott has only 1 per cent of his personal portfolio invested in technology and currently puts no technology funds on his buy list. But he still thinks three funds to look at are SG, New Star and Henderson. Of these, he picks out SG due to its "very experienced manager" Alan Torrie and its "steady track record".

Mark Dampier has some of his own money in Artemis New Enterprises, run by Lindsay Whitelaw, which has massively outperformed all other actively managed technology funds over five years, returning over 67 per cent. He is not, however, so taken with the prospects for the sector that he is actively recommending it right now to his clients.

You should also look at the Close FTSE techMARK tracker fund, which has outperformed all open-ended funds, apart from New Enterprises, over one, three and five years. This highlights the fact that very few open-ended technology fund managers have managed to add any meaningful value whatsoever.

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