Tech sector shedding albatross?

By Nancy Turner | August 23, 2010 | Last updated on August 23, 2010
10 min read

A cursory look at the technology industry’s performance over the last decade suggests the sector has been sucking wind since the tech bubble burst in 2000.

Case in point: a glance at any run-of-the-mill Canadian equity fund reveals that – despite some bumps – ten-year returns are generally positive. Contrast that with the losses, sometimes double-digit, for technology-specific equity funds over the same period, and it sure seems like tech hasn’t yet shed the pariah’s mantle. So the question remains: Did Dot Bomb set the tech industry up for a decade of losses?

For Chip Brian, CEO and founder of SmarTrend Trading Systems in New York, the overall message from the performance charts is negative. As a technician, Brian looks at efficient market theory, with price performance as the driver of value.

“Since the crash, many tech stocks have been in what we call a basing pattern; where large-cap stocks like Microsoft, Yahoo and Cisco have basically traded in a very tight range.” Essentially, the sector’s performance has been “lacklustre – at best.”

But Craig Basinger, CFA, a strategist at Macquarie Private Wealth in Toronto, thinks comparing today’s performance levels to those seen just prior to the Tech Wreck is misleading. “Whenever you look at the ten-year number, it’s extremely start- and end-date biased, and it doesn’t show you anything in between.

“So if you look at the annual returns for the [technology-heavy] Nasdaq over the last ten years, sure there are three whopping huge negative years in 2000, 2001, 2002, but during the recovery period, the Nasdaq was up 50% in 2003, 9% in 2004, 1% in 2005, 10% in 2006, 10% in 2007. Compared to the S&P overall, most of them are almost double what the regular index was doing.”

Alan MacDonald, director of Wealth Management at Richardson GMP Limited in Ottawa, thinks the premise of a decade of losses depends more on whom you talk to. People heavily invested in Nortel and JDS Uniphase might rightly have a very different view than someone who’s held Apple or Amazon for the last ten years.

“Personally, I can recall losing a couple of clients because we refused to put all of their money into technology stocks,” he says. “One fellow had $6 million in Nortel and that’s all he had. And this was actually not that uncommon; I’d talk to employees or executives with these firms, and they’d have their RRSP, employee stock purchase plan, deferred profit-sharing plan, and options all in one stock.

“This particular fellow, ten years ago, was 63, and another guy was 66 at JDS with $5 million in that stock – so suffice it to say those people have been devastated, and they’ll never get back up.”

On the other hand, “there are folks who were in some tech start-ups that didn’t go public at the time, and those companies have stayed alive and they’ve done fine. The companies have earned money and been acquired by larger entities, and those [investors] have made money,” he says.

The Tech Wreck

Perhaps a look back at the emergence of the Internet – for all intents and purposes the prelude to the bust – is warranted. In the mid-1990s, the Internet was a new concept for the average person, but investors and financiers alike grasped fairly quickly the vast potential it had to completely alter lives.

Grace Su, an equity analyst with Global Currents Investment Management in Delaware, entered the industry at the height of the dot-com days. At the time, she says, analysts recognized the potential power of technology, but valuing these new companies proved difficult. With an emerging market, the fundamentals aren’t yet clear, so people develop a dare-to-dream mentality.

“I think the height of the dot-com boom was caused by a lot of creativity, on the sides of entrepreneurs and financiers, about what the Internet could be,” she says.

Basinger echoes this view. “Back then, valuations had no bearing in the technology sector. Companies were being valued on how many eyeballs and page clicks they were getting, and as we know, that’s a long way from an actual dollar of revenue.”

The result of all this speculative activity: a bubble.

“You had the Internet, you had all the infrastructure rolled out to accommodate that, and the big servers were being built,” MacDonald explains. “It just seemed that this thing was going to roll on forever, so investors were content to assign higher and higher multiples.

“And of course, the feedback in 1999 was that tech stocks were up a couple hundred percent and everything else was flat, so it seemed right to allocate more and more of your resources there. That’s similar to every bubble in that there’s a core of truth to what’s going on but then it gets blown out of proportion. And once you’ve got stocks trading at 80 and 100 times earnings, because of the inflated future earnings expectations, then the bubble inflates.”

And then it bursts.

“The tech bust was no different than any previous bubbles,” says MacDonald. Tulip mania in the 1600s, the railroad boom and bust in the 1800s, various real estate bubbles; even bowling has had its heyday. “In the 1950s,” says MacDonald, “everything associated with bowling went through the roof, because they invented the automatic pinsetters. All of a sudden it was easy for bowling alleys to sprout up all over the place. And the demographics were right, everyone started bowling, and all the analysts said the entire population was going to be bowling within a few years, and if you had any sense, you’d jump on bowling stocks — and everybody did.

“The tech bubble was no different, and in retrospect it’s easy to sit and look back and say, ‘Man, wasn’t that stupid,’ but at the time…”

A new era

In the ten years since Dot Bomb, it would appear investor sentiment is still only lukewarm for technology stocks. Andy Walker, general manager, Content Division, Tucows Inc. and in Toronto, suggests this marks the third era of tech companies.

While the 1960s and 1970s represent essentially the birth of modern-day technology companies and the 1980s and 1990s, with the introduction of the Internet, led into the dot-com boom, the 2000s and beyond symbolize the Age of Reason. “People are jaded; we’re over the invention decade,” he says.

Su admits stock prices are much lower now than at the beginning of the decade, but she also suggests this doesn’t necessarily have anything to do with the potential or development of the companies themselves. She cites Microsoft, Google and Amazon as examples. These companies have grown pretty much unabated, year over year, and have developed a marketplace, she says, but their stock prices don’t necessarily reflect that because “we went from thinking these companies are worth 100 times earnings to now realizing technology’s no different from any other industry, and we have to find a way to value it.”

So while there’s still a lot of skepticism – especially in Canada, where investors are still licking their Nortel, Corel and Gandalf wounds – there are also signs of renewed interest.

“The reality is that [an] enormous technological leap [has] occurred in everything; in cellphones, in computers, in voice technology, in storage technology,” says MacDonald. “All that stuff is real; the only things that were unreal were the multiples applied to it. So what we’ve got today is real businesses trading at real multiples. You look at Cisco or Intel trading at 20 times earnings. A bank trades at 12 or 13 times, so you simply have investors valuing technology stocks like they would just about any other industry.”

“I think [the technology sector’s] attractively valued, to be honest,” Basinger says. “You have a lot of faster-growing companies that have very little debt and lots of cash. As far as near-term, we’re pretty positive at this point in the cycle.”

Basinger also suggests the recent emergence from recession is where the tech industry generally does well, ahead of the market. While companies across the board remain hesitant to add heavily to their full-time employment bases, they’re willing to invest in upgrades to existing technology to increase productivity. MacDonald’s seeing this first-hand: “I’ve got a number of executives as clients, and they’re very aware their technology platforms are creaking and they’re just putting band-aids on them until capital budgets are approved.”

This should drive – and likely has been driving, for the second quarter’s reporting season — earnings within the technology space going forward. Throw in the positive sentiment surrounding industry darlings like Apple and Google, and a better handle among analysts on how to value tech stocks, and just maybe we’ll see a bit of magic return.

But even if this is the case, there’s still the job of distinguishing the winners from the losers. This is particularly difficult in technology, where people are fickle and companies require constant innovation to stay relevant and competitive. Su terms this the obsolescence factor.

“In tech, a lot of what’s hot now is the social networking,” she says. “Facebook and Zynga [Game Network Inc.] (they’ll go public this year), etc. There’s a lot of hype around that; there are a lot of organic page views, and that’s very powerful for advertisers.

“The flip side is I’m pretty sure I’m going to pump gas in my car five years from now; I’m not sure that I’ll play FarmVille. So I think it’s very difficult to feel comfortable with the staying power of a certain product or company.”

Where does that leave investors who have some interest in the tech industry, then? What do the experts see as the sector’s best bets?

Ones to watch

The new generation of investors, in Su’s opinion, are really big on what she calls mass customization: “They like choice, and they like being able to personalize things, and to be able to express themselves whenever and wherever they’d like. [They’re] very networked.”

Others agree social networking is a theme that’ll likely continue to play out. Porter Bibb, managing partner at MediaTech Capital Partners in New York, sees “Facebook and Google battling for supremacy on the net; Facebook because it has more traffic than Google, and Google because it has more systems and more offerings than Facebook.”

Another trend appears to be innovation and design, as opposed to invention. “Most of the technology has already been invented,” says Bibb. “It’s now really up to the developers to put applications in.” He also believes anything mobility-related looks set to win. “Wireless is going to rule the day. There are 850 million mobile phones operating in China [alone].”

With the focus on ubiquitous computing and connectivity through mobile devices, Walker thinks telecoms are a sector to watch. “Applications for smartphones [are] critical; but they’ll have to keep up. If they can provide [service] at affordable levels, then they’ll win.”

Consolidation is also on the rise.

“In the old days,” says Brian, “we could delineate between a pure hardware play, a pure software play, a pure network play. If you look at IBM for instance, getting away from the pure mainframe technology business and getting into integration; or HP Compaq — getting away from pure hardware, having that dip in the middle and really recovering and saying consulting and services are where the money’s made.

“What they’re really saying is, broad-based technology capability. For an organization to succeed, [it] has to be able to serve the entire segment, from enterprise all the way down to individual user. And if you extend the user you almost end up in the user’s pocket, so we’ll call it mobile.”

On the flip side, MacDonald reckons small software companies are going to be quite challenged going forward, as cloud computing continues to make inroads.

“You’ve got companies like Google putting all kinds of apps for free on their sites; you can get workable versions of Excel and Word and a lot of different software programs. I think if you’re in the business of creating nifty niche software programs, it’s going to be tougher to avoid being crushed by someone like Google, which may take an interest in what you’re doing and go ‘yeah, we’ll create something like that and stick it on our service for free.’”

Basinger sees trouble ahead for computer hardware manufacturers. “The PC business continues to get lower and lower margins; even Apple’s [Macs] are a lower-margin business than a lot of their others. And I think the trend of pressure on PC margins is likely to continue.”

Bibb echoes these sentiments: “The laptop and the PC are going to slowly disappear. PC sales are very soft right now. Dell is going to get killed if they can’t come up with a viable tablet, because no one is going to buy PCs in the future. And laptop sales are beginning to get soft as well.”

And though Bibb predicts more Internet companies will fall by the wayside, it’s no cause for concern these days. “That’s not a tech wreck, that’s just basically competition,” he says.

He also disputes the premise of a bad ten years for the tech sector.

“It’s not a decade of losses. Google has $30 billion in cash on hand, Microsoft about $22 billion, Intel and Cisco and the other major companies in technology are all [experiencing] record sales and [have] huge cash reserves. You can’t say anybody who’s got $30 billion in cash has had a bad ten years.”

Nancy Turner