Five reasons to love tech funds again

Looking for growth? If you’re feeling brave, I know where you can find it: technology stocks. I know, you swore off the sector after losing your shirt on Nortel back in 2001. That turned out to be a wise move. If you invested in a technology fund 10 years ago, you would now be looking at an average loss of nearly 10% per year.

But it’s different now. Really. Technology stocks are no longer grossly over-valued, for starters. The whole sector has come crashing down to earth. Not only is the sector more attractive by historical standards, but arguably, compared to most other market sectors as well.

Today, the average price-to-earnings (P/E) ratio of a typical U.S. technology mutual fund is 21 times. That’s approximately half of what it was 10 years ago. In March of 2000, at the crest of the dot-com bubble, the NASDAQ Index average P/E ratio peaked at an absurd 47 times earnings. It’s true that a P/E ratio of 21 is still high compared to the overall S&P 500 average of 16. However, technology stocks have always commanded a sizeable valuation premium over other sectors, and there are some good reasons for that. You might not want to jump in with both feet, but here are five good reasons why it’s time to give tech stocks another chance:

Tech is growing fast
Forrester Research estimates IT spending will grow by 9% this year and 7% next year. Compare that to the expected GDP growth of 2% or 3% for the overall economy. As well, technology companies are projecting an average earnings growth of 15% to 20% next year, versus 7% or so for the broad market. Investors expect the faster growing earnings to catch up with higher stock prices, which justifies the higher P/E multiple.

Even better, that valuation premium isn’t as high as it appears to be. These days many technology companies have tons of cash on their balance sheets, averaging between 10% and 20% of their market capitalization. Microsoft, for example, has cash assets representing some $4 per share. That means if you bought the company’s stock today at $25, you’re really only paying $21. After adjusting the price of the shares for the value of the cash on hand, Microsoft’s P/E ratio drops from 12 times to 10 times. Several technology stocks have become so cheap that they are now considered true value picks. Because of all that cash, the average technology P/E ratio is actually more like 18 or 19 times, not 21.

Tech is transparent
Tech companies got a bad rap during the dot-com bubble for promising the moon before they even had a penny in earnings. Internet darlings that actually lost money on most of their sales still saw their stock prices shoot up (remember Pets.com?). But today it’s easier to understand a tech company’s earnings reports and balance sheets than those from companies in other sectors. Some five years ago, new accounting rules paved the way for cleaning up the stock options fiasco. Since then, earnings reports have become more transparent, with less room for accounting shenanigans. Unlike banks, which have a zillion ways to hide bad loans, or commodity-based companies, which use complex models to estimate the value of their reserves, technology companies’ earnings are largely made up of simple, pure cash flow.

Tech is (almost) recession-proof
Technology products have increasingly become part of our daily life. These are no longer discretionary spending items: in many businesses, if you don’t have a BlackBerry or an iPhone you can’t compete. Our unwillingness to give up such technology once we’ve grown accustomed to it has made the sector more defensive in nature, and more resistant to economic down cycles.

Yes, companies may put off upgrading their computers, software, routers and servers during times of hardship, but they won’t give them up altogether. Besides, corporate balance sheets are flush with cash right now—unlike debt-laden consumers and governments. Right now corporations are capable of spending big bucks on technology to improve productivity, making tech one of the few sectors that could see above-average growth despite the current hard times.

Tech is global
Technology has innovation on its side, and that boosts both productivity and demand. (How many people do you see lining up for a new detergent or soft drink formula the way they do for the latest iPhone or iPad?) That excitement is spreading around the world. In fact, the sector is now considered a second-tier play on emerging markets growth. As consumers in India and China become wealthier, they’re quick to upgrade the technology they use. Those markets present a phenomenal opportunity for many sub-sectors, particularly telecommunications equipment. Despite cut-throat competition between Apple, Research in Motion and Google, all three of them are enjoying strong growth in global smart phones sales.

Tech pays dividends
Believe it or not, some tech stocks are becoming dividend cash cows. Distributing surplus cash—as opposed to retaining it for growth—is becoming increasingly engrained in the corporate culture of the larger, more mature technology players. Microsoft’s dividend yield is currently 2%, similar to the overall market yield. Intel is yielding a juicy 3%. Other high-tech companies that used to pour all of their surplus cash into research and product development are likely to follow suit.

Of course there are risks too. You probably don’t want to invest too heavily in tech if diversification is important to you. Just a few large players make up the bulk of the sector’s market capitalization. Apple, for instance, currently represents a full 20% of the NASDAQ Index. The Dow Jones U.S. Technology Sector Index is also top-heavy, with the five largest member companies representing nearly half of the portfolio. Similarly, in Canada pretty much all of the S&P/TSX Capped Information Technology Index is made up of just five companies, no more.

So while the long-term prospects of the big technology indexes are good, short-term, investors could be in for some serious volatility. If you don’t have the stomach for wild roller coaster rides, a more diversified, actively managed mutual fund might serve you better than a passive index fund, as the fund manager can help to smooth things out.

In the “Tempting Technology,” chart below, I list some actively managed technology funds that have managed to report positive returns over the past five years—despite the massive losses incurred in 2008. If you look at their top holdings you will see the same index heavyweights: Apple, Google, Microsoft and Cisco. I recommend them as a good way to get some technology exposure, as they are more diversified than the index funds. Keep in mind, though, that higher growth always comes at a cost—so even the best technology mutual funds will have a tumble or two along the way.

Tempting Technology