Key Points:

• The sector started the year strongly but corrected sharply with rising risk aversion that clouded the market in 1H 2011
• Despite the poor performance, we continue to find compelling reasons to remain bullish on the sector.
• The technology sector’s valuation premium versus MSCI AC World index is at an all time low
• The technology sector has one of the best profitability and/or growth profile
• The sector achieved record earnings in 2010 with the trend expected to extend further
• Technology sector may have a potential upside of 44.0% by the end of 2012 (in local currency as of 20 June 2011)

Global investors’ appetite for risk was significantly dampened over the last two months as the market was flooded with negativity arising from slowing global growth as well as re-ignited European debt woes. As a result, risky asset prices corrected, giving up gains made year-to-date, with some even in the red.

At the end of 2010, we highlighted our conviction in the global technology sector (see iFAST's Key Investment Ideas for 2011, point 5 - Resurgence of optimism about technology, 10 years on). However, on a year-to-date basis, the global technology (represented by MSCI AC World IT Index) was the second worst performing sector, down 5.0% versus a 0.5% decline in the MSCI AC World index. Best performing was Health Care sector followed by the Consumer Staples sector, which gained 9.4% and 5.0% respectively (see chart 1).

Chart 1

Technology sector was hit by risk aversion

While on a year-to-date basis the technology sector’s return is disappointing, the sector has actually started the year with a strong outperformance over the MSCI AC World index. However, with the onslaught of the geopolitical instability in Middle East, technology stocks retreated as investor confidence dived. Nevertheless, the sector performed on par with the general market until Japan’s triple disaster hit. With Japan being an important technology hub, supply disruption affected near-term profitability of the global technology sector. The technology sector’s underperformance narrowed soon after, only to be stopped by a rise in global risk aversion ignited by renewed European debt woes (see chart 2).

Chart 2

Is the Tech Rally Over?

As the Technology sector surrendered earlier gains due to rising risk aversion, it is inevitable that investors start wondering if the rally still has room to run. Looking at the underlying fundamentals as well as some valuation metrics, we continue to find some compelling reasons to remain bullish on the sector. We list the reasons below.

#1: Valuation premium versus MSCI AC World at all-time low

On a historical basis, the technology sector has traded at a premium over global equities in general. Given the higher growth opportunities as well as being the forerunner of innovation, the market is willing to commit a premium for owning technology companies, once even to excessive levels that did not appear sustainable, which eventually led to the technology bubble bursting in early 2000s (see chart 3).

Chart 3

However, excluding the recent financial crisis period, the technology sector is currently trading at a record low premium of just 5% above the MSCI AC World. At current level, the market has discounted the sector’s higher rate of growth, which we do not believe is justified. The valuation premium is likely to normalise once risk appetite return to the market and investors are once again willing to pay for rapid growth.

#2: Technology sector has one of the best profitability and/or growth profile

With reference to chart 4 (data from Bloomberg, as of 20 June 2011), among the 10 GICS Sectors, the technology sector has one of the highest profit margins of 18.3%, second only to the financial sector. This highlights the ability of technology companies to convert sales to earnings. However, the technology sector has also the lowest dividend yield of 1.4% compared to a 2.6% dividend yield for the MSCI AC World index. Earnings not paid out in dividends will be used for future growth, which is a function of retained earnings and return on equity (ROE).

Chart 4

Incidentally, the technology sector has the second highest ROE of 28.5% compared to a 20.8% for the MSCI AC World index. This reaffirms the high growth nature of technology companies and hence the valuation premium it used to trade at versus the MSCI AC World index. Lastly, the technology sector has one of the highest cashflow-to-sales (CF/Sales) ratio, a metric which measures the ability of a company to generate cash flow from sales, with a high value indicating sustainability.

#3: Rising earnings trend at record level

With strong earnings capabilities and an above average rate of growth, the technology sector has managed to recover swiftly from the recent financial crisis. Rebounding from a crisis low, the technology sector has managed to reach record earnings in 2010 and is projected to best itself consecutively over the next three years (see chart 5).

Chart 5

With the MSCI AC World IT index trading at 91.21 (in local currency as of 20 June 2011), the market trades at a forward PE ratio of 12.7X and 11.1X based on 2011 and 2012 estimated earnings. Assuming a reversion to a mean of 16.0X earnings, the market may have a potential upside of 44.0% by the end of 2012, a return which should appeal to investors.

Conclusion

If you find yourself excited over any or all of the above three quoted reasons and can stomach the risk involved, the Henderson Global Technology offers significant exposure to US technology companies (71.5% based on end April’s factsheet). The fund has been one of the stronger performing technology funds with a long track record and has consistently kept its position in our recommended fund list over the years. However, if you prefer a lower US concentration, you may consider the Aberdeen Global Technology fund which has a broader geographical diversification (35.4% to US, 11.2% to Taiwan and 10.8% to Japan etc, based on end May’s factsheet). In either case, we suggest the above to aggressive investors only and investors should limit such holdings to their supplementary portfolio and avoid overconcentration by limiting the exposure to 10% or lower.