When the Internet bubble popped, technology funds collapsed. During the three years ending in February 2003, the average fund in the category lost 79.7 percent, according to Morningstar. That sent shareholders fleeing, and many investors are still reluctant to consider technology funds. But since the big technology downturn, the sector has been quietly recovering. During the five years ending this past April, the funds returned 11.9 percent annually--more than a percentage point better than the Standard & Poor's 500 index.
Now technology could be poised to continue its revival. While the economic slowdown is hurting some companies, many producers are enjoying strong sales from exports and hot consumer gadgets. S&P estimates that earnings for the information technology sector should climb 23 percent in the second quarter compared to the period a year ago. Based on estimates for 2008, the technology stocks in the S&P 500 command a price-earnings multiple of 18, down from 26 in 2004. Make no mistake: Technology stocks remain volatile. But by buying technology funds, investors can add a dose of growth stocks--and prepare to benefit from the next market surge.
To find the best choice in the category, Wealth Manager again turned to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that have more than $75 million in assets and are at least three years old. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.
The screens reduced the field of 267 funds to 51 finalists. Top performers included Allianz RCM Technology, Firsthand Technology Value and Turner New Enterprise. But we awarded the title to Columbia Technology, which had the highest five-year returns.
The fund won the contest by focusing on stocks that seem poised to enjoy big earnings spurts. Portfolio manager Wayne Collette favors companies with breakthrough innovations. To limit risk, he avoids paying high prices for fledgling operations. Collette says that when a promising product appears, Wall Street analysts overhype the advance and push up the share prices of companies that stand to benefit. Soon, as expectations become more realistic, share prices drop.
Instead of buying during the period of early excitement, Collette waits until the new product has demonstrated some staying power. "During the hype phase, stocks are overvalued, and there are no revenues to support share prices," he says.
To determine whether a company has staying power, Collette pays close attention to its market share. Companies with new products often gain 1 percent market shares as early adopters become intrigued. But Columbia does not buy until a broad group of customers shows interest. "I want to find companies that have 10 percent market penetration--and have the potential to grow to 50 percent," he says. "When a company has a substantial penetration, then it has proven itself."
Collette points out that beginning around 2000, Wall Street analysts began hyping companies that promised to provide wireless services for laptops and other computers. Many wireless companies went public, and most collapsed. "If you made an early bet on wireless, you probably lost everything," he says.
Only in recent years, Collette began investing in Broadcom and Atheros, makers of chips that are used for wireless systems. "Now we know that wireless is a proven technology, and these companies will dominate their markets," he says.
Collette aims to buy a stock and hold it for a run of two or three years. But he will sell sooner if the sales begin to slow or the share price seems too rich. To avoid disappointments, he focuses on companies with healthy balance sheets, high returns on capital and improving profit margins. Such strong businesses have the staying power to sell new products in competitive markets. For protection, Collette stays diversified within his sector, holding a mix of hardware, software and telecommunications stocks.
Columbia has been avoiding most wireless telecommunications companies because they face ferocious competition. Instead, the fund owns American Tower, which operates the towers that are used by all the wireless companies. As cellular usage increases, American Tower should report growing earnings.
A favorite holding--one that seems likely to continue thriving for some time--is Nintendo, maker of the enormously successful Wii game. While rivals Sony and Microsoft have focused on reaching young males, Nintendo has attracted consumers of all ages with systems that allow users to play tennis and other games. "Nintendo is generating demand that hasn't been there before," says Collette.
The fund has scored big gains with Apple. Collette began scooping up shares as the iPod gained traction. As the stock skyrocketed, he began unloading some stock.
Columbia buys stocks of all sizes, emphasizing small stocks some years and focusing on blue chips at other times. In 2003, the portfolio holdings had an average market capitalization of $2.1 billion; today the figure is $14.5 billion. Collette says that lately, he has been favoring big stocks. The giants have the purchasing power and economies of scale that should help the fund navigate through today's rough markets.
Stan Luxenberg (firstname.lastname@example.org) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.