From the February 2012 issue of Investment Advisor • Subscribe!

February 1, 2012

Rising Tech

Niche solutions, cloud computing and growth in Asia are expected to buoy the tech space in an overall risky economy

To speak about innovation in technology would be almost redundant. After all, there can be no innovation without technology, nor technology without innovation.

Yet innovation, no matter how exciting it may be, is a scary concept, particularly in scary times.

“Convincing people of what’s beyond the unknown is tough,” says Kevin Landis, president and chairman at Firsthand Funds. “Technology has historically offered the best prospects for growth because it’s all about opening up new markets, but when you do that, you also add a lot of unknowns. To an investor trying to make it through tough times, unknowns mean blind risk, and people tend to shrink away from that in times like these.”

Nevertheless, technology also has a certain “undeniability” to it, says Landis. “You may have looked into the first iPhone and thought Apple was nuts to get into it, but then you’ve seen how successful it is, and you can see that the trend is very real.”

Landis firmly believes that this is the case for technology as a whole. As much as the sector has been affected by the general market downturn, the future potential that the vast world of technology offers is great, he says, but investors are wary about getting involved.

The technology sector—which is so large and diverse that it spans the gamut from classic IT to sectors like semiconductors and alternative energy—is also far more robust than it was in the run-up to the 2001 meltdown. Tech experts are convinced, though, that the complete destruction experienced then cannot happen again for a variety of reasons, not least the fact that technology companies the world over have strong balance sheets and solid cash reserves.

The tech landscape is also very different today than it was before the 2001 blow-up.

Phil Tasho, TAMRO Capital Partners“In 2000, you had so many fantastic offerings and so many different companies with great ideas that wanted to take advantage of what the Internet had to offer,” says Phil Tasho, (left), CEO and CIO of TAMRO Capital Partners, “but the infrastructure just wasn’t robust enough for them to be able to do so. There was really no ability to go forward, even though investors believed that growth would be exponential. Now, there is tremendous connectivity in the marketplace, and that will allow for so many companies to go forward.”

Prior to 2001, technology was a space where valuations were based on expected future earnings, but no one really knew when or how those earnings were going to materialize, says Ryan Issakainen, senior vice president and ETF strategist at First Trust Advisors.

“Fast forward a decade and the cash flow and earnings are there to substantiate what was just hope for many technology companies just a few years ago,” he says. “There is a lot of forward-looking innovation to come. Globalization and the expansion of technology into markets where it hasn’t been utilized before will help to support growth going forward.”

Tech experts say that those dynamics will also help trump the overall macro risk both in the United States and overseas. They’re expecting technology to be the biggest investment trend over the next decade. Here are some of the key drivers for the sector they believe investors need to stay abreast of.

Concepts and Solutions in Niche Markets

One of the greatest drivers for the technology sector is the need for holistic solutions that will enable companies to be more efficient in their businesses.

In an environment where credit continues to be tight, CFOs need to keep strict tabs on their companies to make sure that they’re as lean and mean as possible, says Greg Estes, lead portfolio manager of the Intrepid All Cap Fund (ICMCX). Smaller players that can provide specialized services are the ones that will have a comparative advantage, he says, and will make for some of the best investment opportunities going forward.

Greg Estes, Intrepid All Cap FundEstes, (left), gives the example of CoreLogic, a spin-off from First American Corp. and a provider of a proprietary database that allows financial institutions to make queries on the creditworthiness of individuals to whom they’re looking to extend credit. The more specific or detailed the query, the higher the margin that CoreLogic earns, Estes says, which means that “this company is a market leader in what it does and so it is not subject to cyclicality and maintains high growth,” he says.

TAMRO Capital’s Tasho likes companies like AthenaHealth, an electronic medical recordkeeping and billing company and a niche player in a sector where automation is becoming more and more the norm, and where technology has tons of potential.

“The movement of electronic recordkeeping [...] is a growing trend in health care, and AthenaHealth has carved a niche for itself doing this for very small physician practices,” he says. “The company has been doing this for 10 years, but they have only a 10% market share, so this is a killer category to invest in.”

Tasho believes in looking for innovators, companies that are making their mark and have a competitive advantage over time based on the particular solution they offer clients.

“Companies need to keep moving forward with technology so we’re looking for names that can provide unique services that resonate with the marketplace, and are not affected by the downturn,” he says.

The Cloud

Ryan Issakainen, First Trust AdvisorsShared resources, shared information, shared services—putting everything out there, basically. That’s a scary thought, says Issakainen, but it’s inevitable, because cloud computing is going to be the biggest tech driver for the future.

“Cloud computing greatly improves the way companies deploy capital and how they are investing in information technology,” Issakainen says. “Cloud computing makes everything more efficient and also allows a company’s IT personnel to be productive in ways that are more than just maintenance.”

For tech investors, the most interesting part of the cloud computing trend is the prospect of increased M&A activity in the sector. More and more large companies have been acquiring smaller, more specialized firms, Issakainen says, and he expects the number of deals to pick up in 2012.

“It makes sense for tech investors to own some of those potential targets,” he says.

Cloud computing is one of the most important trends in information technology in over 30 years, says TAMRO Capital’s Tasho. Companies like Oracle are looking to buy smaller companies that have niche specialties because they want to improve their efficiency and bridge the gaps in their business process between strategy and execution, he says, in order to make sure that they’re giving their customers “the right thing at the right time.”

“Huge service companies like IBM and Dell want to offer the complete solution, so they’re investing in specialty companies. We’re going to continue to see a consolidation in cloud computing through these kinds of acquisitions,” he says.

That said, embracing the cloud is easier on an individual level, says Jim Farrish, founder of investment advisory firm Money Strategies Inc., as evidenced by the success of social media and networking sites like Facebook. It’s much tougher for companies to accept the trend, he says, because security is a big issue and “you can never be 100% certain of who’s seeing your data when it’s somewhere out there.”

Nevertheless, when behemoths like Oracle, IBM and Microsoft start buying up businesses that put them in the cloud, the trend is here to stay, says Farrish.

IBM’s acquisition of cloud-based analytics company DemandTec, which connects more than 400 retailers and consumer products companies, is the perfect example of the kind of cloud-based M&A activity that is going to increase in coming years, Tasho says.

“DemandTec is a leader in its field, and it’s the kind of acquisition that allows a company like IBM to better understand consumer behavior,” he says. “Like Amazon, which was the first to start as a cloud company, many large companies now want to innovate and provide their customers with the best possible experience.”

Eye on Asia

It would be short-sighted to talk about the future growth potential of technology without speaking about Asia, which according to Michael Oh, co-portfolio manager of the $153 million Matthews Asia Science and Technology Fund (MATFX), will be the high growth destination for both technology and science over the next decade.

Michael Oh, Matthews Asia Science and Technology Fund“If you look at Asia over the past decade, it’s been about cheap labor and capital inputs for growth,” Oh, (left), says, “but there’s been a huge wage inflation in Asia and many companies are shifting to technology in order to increase productivity growth without hiring more people. The rationale [for the fund] was and still is today that the tech sector will play a greater role in contributing toward general economic growth.”

As Asian economies continue to grow, people’s discretionary income will also increase, which means they will be spending more on tech-related goods and services. Given the size of the populations in countries like India and China, Oh believes that Asia is going to become one of the world’s largest markets for tech-related goods and services, not just in terms of consumption, but also with respect to innovation.

“The Asian market is becoming big enough to support its own innovations,” he says.

Take the Internet, for instance: “The Asian market is one of the biggest in terms of population and the dominant companies are the local ones. The Internet penetration rate in China is only 34%, and the overall penetration rate for Asia is only 22%, even though Asia has the greatest number of Internet users in the world, which means the growth potential over the next 10 years is huge.”

Oh advocates a focus on local companies rather than global firms that have an Asian presence. Domestic companies, he says, will allow investors to better capture specific local market growth stories and benefit from local market growth.

TAMRO Capital’s Tasho gives the example of Baidu, China’s answer to Google, as one of the fastest growing and most profitable companies, which continues to benefit, he says, from the increased adoption of the Internet in China.

Firsthand Funds’ Landis has had a great deal of success over the past five years with China Mobile (which is also one of the top 10 holdings in the Matthews Asia Science and Technology Fund).

But investing locally in Asian tech does come with its fair share of risk, in particular very weak intellectual property protection.

“This is one of the key challenges we highlighted many years ago, and it is improving, particularly in countries like South Korea, which has really been stepping up in terms of protecting patents,” Oh says. “As more innovation takes place in Asia, it will be natural to provide greater patent protection.”     

 

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