Keypoints:

• The fund manager believes that on a relative basis, the technology sector offers an excellent risk-to-reward trade-off relative to other equities
• The reducing cost of technology means that the demand for these products is exploding, especially in the Global Emerging Markets (GEM)
• The fund manager advises investors to be wary of hypes: "Too many times we have seen good ideas being ruined by capital flocking to “hot” areas and valuations being driven to levels that cannot be justified"
• The fund manager believes the combination of secular drivers, downside buffers and attractive valuations will help the technology sector to outperform in good, bad and mediocre markets
• The fund manager says the technology sector is not as economically cyclical as what some investors think, given the high level of recurring revenue generated by many technology businesses, which acts as a strong buffer in a market downturn
  

In this fund focus article, we spoke to Stuart O’Gorman, Director of Technology and fund manager at Henderson Global Investors (Henderson), on the prospects of the technology sector as well as on the fund that he manages, the Henderson Horizon Fund – Global Technology Fund. This fund is available to Malaysian investors through the TA Global Technology Fund (TAGTF), a local feeder fund which invests a minimum of 95% of its net asset value (NAV) in the Henderson Horizon Fund – Global Technology Fund A2 (target fund).

outlook on the technology sector

iFAST Content Team (“iFAST”): What makes the technology sector an attractive investment?

Stuart O'Gorman (“SOG”): A lot of the investors are of the opinion that the technology sector is an economically cyclical sector. However, this is not really the case given the high level of recurring revenue generated by many technology businesses, which acts as a strong buffer in a market downturn. In fact, the technology sector has a beta below 1 over the 3-year and 5-year periods. When market was down last year, the technology sector has outperformed global equities.

We also believe that, unless there is a major turnaround in the global economy, there will probably be cuts in the technology earnings going forward. However, such scenario is likely to be less severe as compared to other areas of the market. The combination of secular drivers, downside buffers and attractive valuations will help the technology sector to outperform in good, bad and mediocre markets.

iFAST: What is your outlook on the technology sector for 2012?

SOG: The technology sector has had a very strong relative performance over recent years and we continue to believe that on a relative basis, this sector offers an excellent risk-to-reward trade-off relative to other equities. Several key reasons why this is so:

• The technology sector is at historically low valuations relative to the market
• Technology or technology-related companies have extremely strong balance sheets and cash generation capabilities with high levels of recurring revenue
• Flexible business models and cost structures
• Exciting new product cycles that can spur new markets
• Disintermediation of “old economy” business models by the Internet
• Demographic shift away from digital refugees to digital natives
• Corporate spending on technology is below trend

iFAST: What are some of the trends or opportunities you expect in the coming two years?

SOG: There is a lot of excitement going on in the technology sector at the moment. Consumers are spoiled for choice as digital products, especially those related to wireless connectivity which penetrates and influences our lives on an ever increasing basis. The very nature of how we interact with friends, at work and even connecting with the media are being revolutionised by these devices. The reducing cost of technology means that the demand for these products is exploding, especially in the Global Emerging Markets (GEMs).    

Corporations, who have long viewed technology as a necessary cost that should be controlled as much as possible, are changing their views and now see technology as a way to help grow sales and reduce other costs within their businesses. This is being driven by a large number of innovative product cycles such as virtualisation, mobile working and the ever growing Internet just to name a few.

iFAST: What are the risks that may derail the technology sector in the coming two years?

SOG: While we wholeheartedly agree that the aforementioned trends present opportunities, we must remind investors to be wary of hypes! Too many times we have seen good ideas being ruined by capital flocking to “hot” areas and valuations being driven to levels that cannot be justified. Investors keep forgetting that “revolutionary technology” companies are not immune to future revolutions from other players, and have commonly mistaken cyclical strength for secular growth. 

Another risk would be the “new cycle”, “cloud” and “digital revolution” stocks that are popular with technology fund managers. We believed that these stocks were simply a leveraged way to bet on the success of quantitative easing (QE), as so many “stock pickers” have found out (to their cost) in 2011.

Also, the technology sector may struggle on a relative basis in a rampant bull market. If we have a strong and sustainable global recovery, companies with bad balance sheets, fixed cost structures and other weaknesses will be the strongest performers. The average technology company does not fit this description. Hence in a rampant bull market, the absolute returns of technology companies will be very good, but still weaker relative to other companies. Unfortunately, we view a strong and sustainable global macro rebound as the least likely macro outcome given the market conditions that we are currently in.   

iFAST: Can you give us an example of a company that the fund has invested in?

SOG: Apple Inc. (Apple) has consistently been on the Global Technology team’s favourite list. Apple is the largest holding in the Henderson Horizon Fund – Global Technology Fund and it will likely remain so based on the “stickiness” of its ecosystem (iTunes, App Store and now web services), its leadership position in some of the fastest growing markets as well as having a very attractive valuation. We first purchased this stock in May 2003 at a price of USD8.46 and it is currently trading above USD500. From a valuation perspective, the stock remains attractive at an estimated PE of 12.5X and 11.0X (Bloomberg consensus estimate as of 13 March 2012) for 2012 and 2013 respectively, which still remains at a significant discount to the S&P 500 and the technology sector.      

iFAST: What about examples of companies or sectors that you are bearish on?

SOG: It has been a very tough year for most of the communications equipment stocks, with the sub-sector being one of the worst performers within the technology sector in 2011.

Many of the structural businesses that are poorly positioned such as Nokia Corporation (Nokia), Research In Motion Limited (RIMM) and Alcatel-Lucent have continued to implode, while investors have realised that not even the “next generation” or “new cycle” technology companies deserve a PE over 40.0X next year in a poor macroeconomic environment.

Mobile handsets have generally been a disaster for investors in the technology sector as Apple and Samsung Electronics Co., Ltd. continue to suck profits on an increasing level from the rest of the industry. We believe that this trend is likely to continue going forward.

While there are some valued names with interesting assets such as Nokia and RIMM, we would prefer to see business trends bottoming rather than buying a bad business in the hopes of an M&A. We have a slight underweight position in the communications equipment sub-sector overall.    

henderson horizon fund - global technology fund a2

Chart 1: Henderson Horizon Fund - Global Technology Fund A2 vs Benchmark
Source: iFAST and Bloomberg, iFAST compilations, as at 30 March 2012. Figures are in RM terms, calculated using NAV prices, with any income or dividend reinvested

iFAST: Can you elaborate on the investment team behind the target fund?

SOG: The Global Technology team behind the target fund consists of five members, based in Edinburgh, Scotland.

Ian Warmerdam and I undertake the primary fund management duties, supported by the Investment Manager Gordon Happell, Investment Analyst Giles Tulloch and Fund Manager Assistant Ronan Kelleher.

Chart 2: Global Technology Team of Henderson Global Investors
Source: Henderson Global Investors

Stuart O'Gorman

Stuart O’Gorman, Director of Technology Investment, has more than 15 years of investment experience. He joined Henderson at the start of 2001 and has been the fund manager of Henderson Horizon Fund – Global Technology Fund. Prior to joining Henderson, he spent five years as a specialist technology manager with Aegon Group. Stuart holds a Master’s degree in Financial Economics and a Diploma in Investment Analysis from the University of Dundee and University of Stirling respectively. He is an Associate Member of the Society of Investment Professionals.

Ian Warmerdam

Ian Warmerdam, Director of Technology Investment, has more than 14 years of industry experience. He joined Henderson in 2001 and is the co-manager of Henderson Horizon Fund – Global Technology Fund since 2007.

Prior to joining Henderson, he worked at both Scottish Widows and Scottish Life where his career began as a US Equity Investment Analyst.

Ian has a Master of Science in investment analysis from the University of Stirling. He is an Associate Member of the Society of Investment Professionals and Bachelor of Science in Technology and Business Studies from the University of Strathclyde.

iFAST: What is your current investment style? What criteria do you look at when picking stocks?

SOG: We adopt an active management style with a modest bias towards growth. The investment process is predominantly bottom-up, with a thematic overlay. Thorough fundamental stock analysis is the key to the process and we have a close focus on valuations.

We also pay attention, in particular, to the value proposition that a company offers to their customers and the barriers to entry that a company possesses so that these companies can protect their margins and market share. We believe that the markets often fail to appreciate the profitability of a company with strong barriers to entry, while overestimating the long-term value of those companies possessing no sustainable competitive advantage.

In addition to all these, we also attempt to identify cross sub-sector trends in the technology sector, and use any thematic implications to identify potential investments. This approach also helps the managers to control risk by reducing any unintended thematic risks resulting from a bottom-up stock selection. 

The criteria we look at when picking stocks include:

• Balance sheet
• Valuations
• Market opportunities and competitive positioning
• Barriers to entry and their sustainability
• Factors such as earnings growth and momentum
• The potential of the themes that the technology and technology-related companies are exposed to
• The probability and impact of downside risks
• Technical or sentiment factors

iFAST: How do you manage risk in your portfolio?

SOG: In terms of risk management, Henderson has a series of independent checks that are applied to all asset classes.

We will constantly monitor the portfolio weightings across various levels which include country, sector, thematic and stocks levels. The MSCI All Countries World Information Technology Index is used as a benchmark and the levels of geographic, sector, thematic and individual stock risks are considered relative to this benchmark.

Individual stock weightings are capped at a maximum of 10% although they are rarely greater than 7.5%. While there is no formal cap on relative or absolute sector weightings, we consider a divergence of more than 10% from the benchmark as unusual. We aim to add value from a bottom-up stock selection approach rather than from a sector allocation approach. Finally, as the portfolio is constructed with a thematic overlay, we can readily understand and control the thematic risk that runs across sectors and geographical regions.

As well as having an internal risk management function, Henderson uses an automated dealing system which will flag any breach of guidelines at the time of dealing.

Besides that, Henderson has a dedicated market risk analysis team which ensures that:

• The level of risk taken is appropriate to the objectives of the target fund
• Risk is allocated efficiently in areas where judgment has been made, with no unplanned exposures
• The risk models used are appropriate to the current market and that the exposure has been defined, measured and managed consistently throughout the process

The Risk Measurement team is independent of the fund management teams and reports to the General Manager of Listed Assets. Every month, the team reports on market risks of Henderson’s product range to the Listed Assets Executive Committee. This committee comprises of the senior management from Henderson’s Listed Assets business which include the Chief Investment Officer and the Head of Equities.

iFAST: What is the one investment approach/decision you made that you are most proud of?

SOG: We are most proud of the first purchase of Apple stock in May 2003.

iFAST: What about an investment approach/decision you made that impacted the target fund negatively?

SOG: It would have to be the Netflix Incorporation stock; a US based online movie rental service. This stock was one of the biggest detractors, affecting the target fund’s performance in 2011. The stock performance fell due to increased competition for content and the negative reaction from their customers to the proposed changes of their pricing structure. These caused us to reevaluate our thesis and subsequently, we sold the stock.

iFAST: What differentiates the target fund from other technology funds? Why should investors invest in this fund?

SOG: The target fund has a long-term, secular growth bias with the option to invest in cyclical stocks when the investment opportunity arises. There is a large- to mega-cap bias, where stocks are invested in once the technology has a proven market usage. Beta, volatility and tracking error are monitored to ensure excessive relative risk is not taken. The aim of the target fund is to outperform the benchmark steadily with low volatility.

getting to know the fund manager

iFAST: In your opinion, what are the must-have qualities as a fund manager?

SOG: A fund manager needs to have a disciplined investment approach, never love a stock and have a good sell discipline.

iFAST: What is the fund managers' biggest challenge?

SOG: In a financial world where investors choose to be in or out of the market very quickly, especially through exchange-traded funds (ETFs), the biggest challenge for fund managers are to prove that they can return alpha. By generating alpha, they will be able to retain redemptions and generate subscriptions, making equities worth owning.  

iFAST: What is your biggest achievement?

SOG: It would be being able to grow Henderson’s technology assets under management to approximately USD3 billion.

For more information on the TA Global Technology Fund, please click here.

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