Looked at in isolation, April wasn’t so bad, with tech heavy-indices up about 1.5%, in line with the S&P. Results season started well with Intel responding positively to a very good set of numbers. But things started to deteriorate midway through the month as worries about sovereign debt intensified and tech companies stopped reacting well to good earnings.
LOF Technology outperformed again in April, by 24 bps, and is outperforming the benchmark by 2% ytd, some way ahead of the peer group.
We ended April tactically more defensive than we have been for some time, as we wait for macro issues to play out. But once the correction has run its course, we think compelling valuations and still strong end markets will make the Fund and the sector do very well over the balance of the year.
Trends and outlook
Some people think tech has entered a "supercycle". We’re going to have a look at the arguments about that this month (it was also the topic of our recent morning meeting presentation).
Tech´s supercycle theory states that we are entering a very special time in technology -- overlapping industrial cycles, product cycles and secular economic trends are combining in a way they haven´t done before, creating the potential for massive outperformance. In a supercycle scenario all the current models are wrong; they are far too conservative.
Industrial cycles
Tech is emerging from a period of serious underinvestment. Semiconductor capacity, telecoms networks, corporate IT projects, software upgrades -- all of these were reduced, put on hold or cancelled as a result of the crisis. However, global demand has not gone down significantly since these plans were put on hold, and much of the drop off in consumer demand in developed markets has been absorbed by Asia. The world economy is in catch up mode when it comes to tech infrastructure spending.
However, adding semi capacity and recruiting the staff needed to restart projects takes time, and finding the components to make the network infrastructure is harder while semi capacity is constrained. The result is that the cycle can continue for longer.
Product cycles
There are a few of these: cloud computing drives equipment spending and new business models; mobile computing creates whole new markets and more network spending; the ongoing shift to online provides growth and, again, new business models. Computers and handsets need to be replaced as they get new functionality, with Windows 7 and the current corporate refresh being an excellent example of this. These product cycles have a life separate from industry cycles and provide growth opportunities over many years.
Economic trends
The biggest economic force behind the performance of tech coming out of the crisis has been changes in consumption in China. There was a lot of speculation during the worst months of the crisis about whether China could take up the slack as developed market consumption weakened. In tech, it definitely has.
Chinese incomes are rising to meet falling prices for consumer tech products, whether they be PCs, LCD TVs or handsets. Moreover the government is subsidising these products in a push in rural markets to create a consumer society and regional development. The result is an explosion in unit growth. Asia Pac is already the world’s largest consumer technology market and so makes a large contribution to global growth, driving PC unit growth to over 20% this year, the best PC year in a decade. China is also very under-penetrated in PCs, and India has yet to see income and wealth levels rise (or ASPs fall enough) to see the same growth explosion. That is still to come. So this growth driver is likely to continue for some years.
Supercycle?
Taken together, all these trends add up to a "supercycle", building on each other to make a wave which is much higher and lasts much longer than is reflected in valuation models. Because the supercycle is made up of many smaller cycles and trends, reversals in one or two should not have major effects, so if e.g. semiconductors roll over the impact should be small. The implications for valuations in the sector are also very interesting; a supercycle works to extend and heighten the high growth period in DCFs. The supercycle thesis implies that tech stocks are very cheap indeed.
What do we think? Well, we would very much like to be believers, and think the logic behind the thesis seems sound. Our main concern is partly fear of hubris -- it tends to be when people start talking about supercycles that stocks in the sector stop going up!
More concretely, a big macro shock would be a big risk to the thesis, and we have been quite worried about sovereign risk issues. Another concern would be the fact that a major force behind falling prices and good margins in the tech space over the past 5 years has been outsourcing of manufacturing to China and a large part of this has been a controlled Remnimbi. As China starts to import more, to consume more, that currency will appreciate and wages will likely rise. This makes us a bit more worried about how much more margin expansion is possible in the sector. We may also find a few new more low cost regions to make stuff in -- India, Vietnam, Indonesia, possibly Africa spring to mind -- and that will help.
Overall, we keep a healthy scepticism on the supercycle thesis; but we see the arguments and largely agree with them, bar some concerns. But we don´t need to believe in the thesis to want to own technology stocks. We already see huge potential performance without having to supersize our estimates. The summer may show some weakness, but we think it is to be bought. We encourage investors to take positions the LO Technology Fund, especially on any weakness.
Portfolio report
Networking and Hardware were our winning sectors in April. Semis led to the downside. Single stocks Qualcomm, where we avoided a blowup, and our overweight in Ciena helped, while NVidia in semis hurt.
In April we did more buying than selling as we had inflows, but took a tactically more cautious stance, cutting our high fliers and higher beta stocks such as JDSU and NVidia, and buying Swisscom and KPN to be temporarily more defensive. We also bought Adobe, in software, as we think the market is misjudging their new product cycle.
Our biggest holdings have shifted around a little. In order: Apple, Microsoft, Cisco, HP, and Oracle.
