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© Copyright 2000 Rogers Media. The following article first appeared in the January 2000 edition of
BENEFITS CANADA magazine.
Tiny Bubbles
Technology changed the world in the 1990s. That doesn't necessarily mean
it's a good investment though.
BY CHRIS BLAKE
From an investing perspective, technology has come to define a set of companies operating primarily in the
communications and computer industries. These firms develop technologies that enable productivity growth.
More recently, it has also come to include companies that are applying technology through the use of the
Internet.
They may be providing Internet service, delivering traditional consumer goods and services or enabling
business efficiencies through a myriad of business-to-business sites and virtual networks. Technology has
become universal, employed in virtually all industries as a means of gaining efficiency to drive out costs.
Technology has even been recognized by Alan Greenspan, chairman of the U.S. Federal Reserve, as one of the
reasons for the incredible performance of the economy in the United States--an economy that has continued
to grow at a high pace without experiencing significant inflationary pressures. It is cited as the key to
the growth in productivity, which has accelerated through the 1990s. Technology has transformed the normal
supply and demand relationships that dominate pricing signals for goods. Supply chains are being
re-invented and inventory is being removed from the economy as the supply-push model of business operation
is transformed to a demand-pull model taken from the Japanese Kan-ban method of manufacturing.
Technology is at least partially responsible for the long-term decline in commodity prices, and the
demand-pull model has reduced the amount of inventory in the supply chain. This has led to a reduction in
apparent demand. And, it has increased the ability to find, collect and reprocess scrap materials at ever
lower costs.
THE IMPORTANT QUESTION
Technology is the most exciting, high-growth sector of the economy, and we should probably all have greater
exposure to it in our portfolios. Right? For Canadian pension plan sponsors this is an important question.
How can the plan best capture the exceptionally high returns of this equity sector?
As an investment, technology has really come to the fore over the second half of the 1990s. Within the
Standard and Poor's (S&P) 500 composite index, technology has grown from representing 7% of the index
in 1992, to 24% at the end of October 1999. In the five years ended Oct. 31, 1999, the S&P high tech
composite provided a total return of 468%, for a compounded rate of 41.7% per annum.
This compares quite nicely with the S&P 500, which returned 218% or 26% annually over the same period
(see "Charting tech stocks," right). In Canada, the Toronto Stock Exchange (TSE) 300 composite index has
two technology indexes: Technology--Hardware, and Technology--Software. For the same five-year period, the
TSE Hardware index returned 387% (or 37% annually), and the Software index returned 70% (or 11% annually).
Compare that to the TSE 300, which returned 85% (or 13% annually).
The Hardware index return is heavily affected by the returns of Nortel Networks, which was up 672% (or 50%
annually) during the period.
The field of high tech investment opportunities in Canada is relatively small. Combined, the TSE Technology
Hardware and Software indexes total 27 companies, having a weighted market capitalization of roughly $135
billion at the end of October 1999. Of that figure, Nortel accounts for $90 billion, JDS Uniphase--$10
billion, Celestica--$7 billion, Newbridge Networks--$4 billion, Cognos--$2 billion and the CGI Group--$2
billion.
These six companies represent 85% of the investable space. Obviously, the opportunities begin to drop off
rather quickly in terms of market capitalization. If we start to go much smaller, we are really getting
into the small-cap arena where a significant number of the opportunities for technology investing in Canada
start.
At the time of its initial public offering (IPO), JDS Fitel had a total capitalization of just $344
million. Over the three years that followed, the company grew from sales of $75 million to the most recent
annualized quarterly run rate of US$960 million. Now, after a merger with Uniphase, it has a market
capitalization of US$34 billion. If a purchaser of the IPO held the shares to the end of October 1999, a
return of over 3,000% would have been realized.
While their small capitalization is not a good reason to ignore these companies--don't forget that from
tiny JDSs, mighty Uniphases grow--but small capitalization technology companies can be a minefield for
investors. By virtue of their small capitalization, these companies can have difficulty growing. They don't
always have a good currency for making the acquisitions necessary for growth, or to attract the talent they
need with stock options.
Management may not be up to the task of competing internationally in order to set the standard for their
niche, or they may be resource constrained relative to their competition. For each JDS Fitel there are
scores of companies that fail to realize their initial potential.
Therefore, when there is the slightest hint that the company is losing momentum, the stocks (which usually
have had quite a lot of future growth priced in) are dumped. This leads to the incredible one-day price
drops for which this segment of the market is notorious.
It is not uncommon for companies that disappoint to come down in price by 50% or more before there is a
chance to trade out of them. The potential of great growth carries a high price tag in terms of volatility
for the investor. High tech investing is, on a stock-by-stock basis, risky. It is not surprising that,
individually, these equities generally have higher betas than non-tech companies.
WORLDLY GOODS
Competition in the technology sectors tends to be global. Software, for example, can be written in
Bangalore, India as easily (and at a lower cost) as it can be in Ottawa or San Jose, Calif. Memory devices
are designed in North America and are produced in Korea, Japan and the U.S. Graphics processors, also
designed primarily in North America, are manufactured almost exclusively in Taiwan. Cellular and PCS phones
have become a Nordic specialty. And wire-line equipment, traditionally made around the world, appears to
have become more of a North American specialty. Frequently, different solutions to the same problem are
arrived at in geographically diverse locations almost simultaneously.
To successfully invest in this sector requires knowledge of technological developments around the world.
Competition in the sector is relentless, and is more technologically based than geographical.
As well as being global, competition is marked by a winner-take-all mentality. In general, as new competing
technologies are brought to the marketplace, there is an initial take-up by the early adopter segment of
the target market. And while the companies that lead the sales growth at this point in the technology life
cycle look like winners, they may ultimately fail to capture the greatest segment of the market as the
product transitions to the mainstream.
The result of this type of market is a harsh segregation into winners and losers. The winners tend to
dominate their market, and reap exceptional profits. This makes the outcome of competition much like a
lottery: one big winner, a few smaller winners and a lot of losers.
What we are really looking at here is a class of investing more akin to venture capital than to normal
investing. Indeed, one of the leading mergers and acquisitions specialists on Wall Street noted in a recent
interview that: "Today the public has become a venture capital arm of the financial industry."
LOTTERY WINNINGS
Once again we can look to Alan Greenspan for insight to the market psychology of valuing these companies.
In the question and answer section of his testimony before the U.S. Senate's Budget Committee in January
1999, he drew a parallel between the pricing of technology stocks and lotteries, suggesting that it may
indeed be rational for these stocks to have high valuations.
"What lottery managers have known for centuries is that you could get somebody to pay for a
one-in-a-million shot more than the value of that chance," he said. "And what that means is that when
you're dealing with stocks--the possibilities of which are either it's going to be valued at zero or some
huge number--you get a premium in that stock price which is exactly the sort of price evaluation that goes
on in a lottery."
Although the chairman concluded that despite the hype, this pricing may be "good for our system" as capital
seeks to "ferret out the better opportunities and put capital into various different types of endeavours."
Nonetheless, many observers are beginning to suggest that the lottery premium may be getting a little
large.
Many observers are suggesting that the current froth in the technology sector is evidence of a bubble much
like the Japanese equity bubble in the late-1980s. Morgan Stanley's Barton Biggs was quoted in
Barron's in early November 1999 saying: "As for the IPO market, our technology research team points
out that of the 1,200-plus technology IPOs since the debut of the personal computer in 1980, a mere 5% have
created 86% of the wealth. The 241 major Internet stocks have a combined value of US$549 billion with sales
of only US$24 billion and a combined loss of US$7 billion."
Whether there is a bubble in technology stocks is something we will only be certain of once it has burst.
The key point is that the technology sector of the stock market represents an opportunity to participate in
companies that are growing far more quickly than others.
GROWTH YET TO COME
The question of technology investment is something more for the strategic level rather than the policy
level of the pension fund. Technology is truly a sub-category of equity. Should plan sponsors wish greater
exposure, there are a number of methods of accomplishing this.
First, plan sponsors can simply leave it to the discretion of the equity manager to weight the sector
according to the manager's view of the potential. One of the most important issues for pension plans in
Canada with regard to this sector is the relatively heavy weighting of Nortel Networks in the TSE indexes.
Since equity managers are frequently benchmarked against the TSE, it is important that they have latitude
to properly compete against the index. They should be free to include components up to some level exceeding
the full index weight. This introduces the potential that benchmark risk is traded off for stock-specific
risk.
An alternative method of dealing with the benchmark risk is to redesign the benchmark and then dedicate a
portion of the equity component of the fund to a specialist technology manager. Should this be the chosen
method of dealing, more potential issues fall--foreign content level for one. Since this is usually set
across asset classes, it may be easy to cope with.
Technology has been an exciting equity sector through the second half of the 1990s. Remember that past
performance is no guarantee of future results. However, the Internet, computers and wireless telephony are
not nearly as universal as they have the potential to be. There is growth yet to come. What is important
from this point forward is the level of growth currently priced into these stocks versus what is truly
achievable.
Chris Blake is an investment analyst at Mulvihill Capital Management in Toronto.
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