Technology stocks have presented two related chal- lenges for global value investors: valuation and geo- graphic concentration. Nevertheless, Causeway has found overlooked opportunities in the sector. To shed some light on investing in information technol- ogy (IT) stocks, we spoke to Jamie Doyle, portfolio manager, and Brian Cho, technology research analyst.
Jamie, why is it so difficult to find undervalued in- vestment opportunities in the IT sector?
JD: The valuation challenge is easy to understand. "Interesting" companies—those with enticing tech- nology or rapid growth in new markets that drives income statement momentum and increases margins— are typically priced very aggressively. At times, this enthusiasm reaches extraordinary levels. The technol- ogy boom of the late 1990s is the most memorable incident. Other examples over the last two decades include DRAM memory, personal computers and social media. Currently, equities exposed to "cloud"– based technology, such as Salesforce.com, have reached nosebleed valuations (although some of this appears to be correcting even as we write this in April).
Technology companies with lower valuations generally have perceived structural problems, such as exposures to a legacy business or the commoditization of what was formerly a differentiated product. The current Microsoft Windows-based personal computer market is a great example. PC volumes are declining, probably on a structural basis, and products have become indis- tinguishable.
In general, across all markets, IT stocks that we want to own are often too expensive, and those with reason- able valuations are often struggling to innovate. What is the geographic challenge?
BC: The vast majority of the most innovative tech- nology companies, especially in software and services, are US-domiciled. We all know these names: Amazon, Google, the aforementioned Salesforce.com, as well as hundreds of other perhaps less familiar companies. On the other hand, emerging markets are home to some of the dominant, ultra cost competitive technology providers, including memory and processing semicon- ductor producers, contract manufacturers, and out- sourced labor.
This leaves developed Europe and developed Asia (i.e., the traditional MSCI EAFE Index markets) somewhat stuck in the middle. As of March 31, 2014, IT rep- resented nearly 19% of the S&P 500 Index. It is the single largest sector in the Index, exceeding financials by more than 200 basis points, and growing much more quickly. Analysts forecast that US technology firms will increase earnings nearly 14% over the next three-to- five years, a growth rate 26% higher than the forecast for the financial sector. In contrast, IT represents a mere 4.5% of the EAFE Index. The MSCI Emerging Markets Index has nearly 17% in IT.