Taking Stock of Technology

The Russell 2000 index came within striking distance of setting a new all-time high during the past month before fear again struck the equity markets, at least for the moment. The stock market paused to assess the possible economic damage from increasing inflationary pressures—oil has surged 20%+ over the past three months—and spreading unrest throughout the Arab world.

Inflation is considered a headwind to the markets and to corporate earnings, but stocks also represent companies with real assets and pricing power. We do not spend much time trying to figure out where the economy is headed or whether or not inflation is coming, preferring instead to focus on finding high-quality smaller companies that are selling at what we perceive to be significant discounts to their worth as a business. One example would be our work over the last several years in technology stocks. Although the small-cap Russell 2000's Technology sector outperformed the index as a whole in the fourth quarter of 2010 and has done so year-to-date in 2011, we believe the case for technology remains compelling.

Today's technology sector is vastly different than the technology sector of more than a decade ago. It is interesting that back in the late '90s tech was viewed by many investors as a permanent growth category that was not subject to the same business cycle dynamics as every other industry. Today, it's nearly the opposite, with investors overly sensitized to its cyclicality. This has created numerous bargains.

Tech stocks in general have been very inexpensive for several years—they've essentially been in a 10-year bear market, which has allowed us to find what we think are extraordinary opportunities in companies across a variety of industries. It is almost as though many investors have lost sight of the fact that technology companies continue to innovate with products and services that save labor and cut costs, both of which are critical in an inflationary environment.

Many companies have deferred normal technology upgrades due to the difficult economy, but upgrades are inevitable because ultimately no business can afford to fall behind in technology. In addition, there is growing demand for all types of technology in emerging market countries that simply did not exist 10 years ago. Many small-cap tech companies currently sport strong earnings and sales growth driven by high foreign exposure and rising business spending.  In fact, according to Bank of America, more than half of U.S. non-construction cap-ex spending is productivity (Information Technology) related. Finally, many small-cap technology companies have pristine balance sheets, with cash as a percentage of market capitalization for the technology sector currently standing at 18%, the highest in the Russell 2000 index.

To be sure, we have often viewed the strategic consolidation of a particular industry or sector as a positive. Earlier in 2010, while equity investors were uncertain about the economic environment in the U.S. and sought the refuge of fixed income investments while shunning equities, larger technology companies were rushing in to buy out smaller peers and competitors. As Steven DeSanctis of Bank of America highlights in a recent research report, "Over 31% of the merger and acquisition deals in 2010 were done in the Information Technology sector." To us, it's generally a good time to invest when the people closest to these businesses are investing.

Stay tuned…
FDG