The Gannon Report

As the credit and financial crisis that began nine months ago continues to play out, the stock market began to shift focus during April to the ongoing economic slowdown. Corporate America has weighed in, reporting first-quarter earnings that were mixed at best. The Russell 2000 advanced 4.19% for the month and was down 6.12% year-to-date through 4/30/08.

One of the worst performing sectors of the Russell 2000 thus far, even with the recent rally, has been the technology sector. From the small-cap peak on 7/13/07 through its most recent low on 3/10/08, the technology sector of the Russell 2000 declined 29.0% with only the financial and consumer sectors—whose respective woes have been far more publicized—performing worse. The tech sector thus represents potentially rewarding opportunities in the current smaller-company market.

Nearly eight years after the bursting of the internet bubble, the tech sector is still recovering from the excesses of the late 1990s. Overinvestment during the heady dot.com years was followed by dis-investment to work out much of the excess capacity. Gina Martin of Wachovia Capital Markets noted in a recent report that "real technology investment as a share of total U.S. business investment has fallen for most of the last three years." Bill Whyman, of ISI Group, was quick to point out that it has taken "U.S. technology spending nearly seven years to get back to where we were in nominal dollar terms relative to the bubble peak in 2000." Current fundamentals for many industries within the sector remain underwhelming.

However, from our perspective, years of dramatic underperformance have also resulted in compelling valuations for many companies, as well as extremely low expectations. From 12/31/03 through 3/31/08, the technology sector of the Russell 2000 was down 0.7%, while the Russell 2000 was up 29.9% for the same period. At the same time, the business models of many technology companies have changed. Most tech companies today have low inventories, strong international sales and solid balance sheets. Our own research shows that at the end of 2008's first quarter, cash as a percentage of total assets for the technology sector of the Russell 2000 was roughly 23%, with only the Healthcare sector higher at 26%. As to our security analysis process, we have most recently been focused on the telecommunications, software, and semiconductor and equipment industries.

It may seem obvious to state that Technology remains an integral part of any competitive business enterprise and economy, but the sector's recent troubles show that many investors may have forgotten this fact, which helps to explain why, following years of underperformance by tech stocks and under-spending by American businesses, we believe that the technology sector is ripe with opportunity.