The biggest risk of investing in technology stocks is arguably chasing the same idea as everyone else. Indeed, buying growth now is a sure recipe for disappointment, according to fund manager William de Gale.
“This is the reason why very few tech funds outperform the benchmark,” explained De Gale, who runs the BlueBox Global Technology fund.
However, the technology sector remains the place to be, he said, with plenty of gains still to be made even after its strong showing in recent years.
“Over the past 10 years, the tech sector has sucked the growth out of the rest of the economy,” he said. “Looking at the S&P 500, we can see that tech’s earnings have grown by 10 per cent per year since 2012, while non-tech earnings have grown by only 1 per cent per year.”
What makes the sector an attractive place to invest, he said, is that about one-tenth of the equity market by capitalisation is earning almost 100 per cent of the growth in profits.
The chart below tells the story of a sector that has monopolised virtually all the earnings growth of the entire economy for the last seven years.
S&P 500 Incremental Operating Income
Source: BlueBox Global Technology
Unfortunately, noted De Gale, the experience of many investors in technology, both professionals and individuals, is rather disappointing.
“You owned the right stock but a bit too late; maybe bought it on some good news, saw it do well for a period, and then go into an inexplicable decline,” he said. “After watching it go down for a few months, you gave up and sold, only to notice a while later that it has bounced sharply – how annoying, you were right all the time!”
Then you buy back in, De Gale went on, promising yourself that this time you will add on weakness, “only to find two years later that the stock that you’ve added to each time it was down 10 per cent has more than halved – even though it still has the best product in its market”.
“What went wrong?” he asked.
The portfolio manager – who has 20 years' experience in the sector, latterly at BlackRock – pointed to what he called the four popular approaches to invest in technology, each of which he finds misguided.
The first is “to buy companies that you’ve heard of and that you use every day”. If you’ve heard of them, so have a lot of other people who also use them.
“You’re not going to find a hidden treasure here,” De Gale said.
The next approach is “to buy companies that are doing something exciting, with a lot of media coverage”. Well, a lot of media coverage means that everyone else has heard of them too, he said.
Then there’s “buy companies that are growing very fast.”
“Please don’t,” De Gale said, adding that fast growth attracts a lot of attention, as everyone is watching these businesses.
The final approach is “to buy companies that are held by well-known investors or funds”.
“This is the most dangerous approach of all,” he said. “Buffett owns a stock? The next thing he does is maybe selling them to you. Even worse, high-profile investors are sometimes offered investments under highly preferential term which are not available to you.”
The bottom line, De Gale concluded, is to steer clear of companies that everyone likes, because lots of upside is already priced into them. With the right approach, he added, an investor can profit from a sector that offers the best investment opportunities in today’s market.
The chart below shows that the technology sector has indeed outperformed the global equity market index for the past decade.
Source: BlueBox Global Technology
The portfolio manager attributes the tech sector’s notable success to a fundamental shift in the very nature of computing in recent years. He said computers are now able to establish what he calls ‘Direct Connection’ with the real world.
Direct Connection is the result of computer systems’ new-found ability to act autonomously in their environments, “without humans acting as input and output device for the system”. Examples of this capability are found in robots, which are able to perform a variety of human tasks, and self-driving cars, “which don’t need a driver to say whether to turn left or right”.
“In the 21st century, computers have come out to meet the real world,” De Gale said. “This has been the underlying theme for my investment approach over the last 10 years or so.”
The impact of this underlying change is massive, he said: “It has only just got started and will continue for many years to come. So, it seems very likely that the technology industry will continue to eat the other sectors alive.”
De Gale said investors need to find something that is under-appreciated, if they want to perform in the tech sector: “If the CEO is on the front cover of Wired, it’s not exactly a secret.”
The fund manager noted that companies that succeed in each industry are those that have spent most heavily and effectively on information technology.
“Companies that are winning are those that look and act most like technology businesses: fintech, healthcare IT, industrial automation, industrial big data, automated supply chains, and online retail, are notable examples.”
This boom is helped along by all the sophisticated HR, compliance and customer-facing systems being rolled out across the enterprise world.
“This phenomenon is an example of the ‘Prisoners’ Dilemma’: if no company made substantial investment in technology, then none would have to do so. But if your competitors are developing exciting new ways of serving the customer, then so must you, even if the cost of doing so reduces your business – and its competitors – to break-even.”
In effect, the excess returns of every other sector are being spent on tech.
“This rush to invest in transformational technology may well do nothing good for the returns of the spenders, who are probably destroying shareholder value in the short run to gain and maintain a competitive edge,” he said. “But it does wonders for the tech sector, the recipient of all this investment.”
“If the excess returns of every other sector are spent on IT, then IT will be the only sector that grows.”
And that is precisely what has been happening in the past decade or so. The information technology sector appears to have earned almost the entire increase in operating income for the US economy, and that has been reflected in its sustained stock market outperformance.
“We don’t invest in technology, but in technology businesses, and these businesses must create value for outside investors. So, we look for four characteristics in our investment.”
The first of these is a strong underlying technology trend, principally Direct Connection. The second is the company’s ability to create value as a result of that trend. Third, a strong barrier to entry. And the fourth is a reasonable division of generated value between outside shareholders and other stakeholders.
Performance of fund since launch in US dollar
Source: BlueBox Global Technology
The BlueBox Global Technology fund holds between 30 and 40 positions (currently holding 31) with a maximum weight of 10 per cent, targeting between $1bn and $100bn market cap. The fund is not benchmark-oriented, has low turnover in its positions and cash at a minimum, usually below 10 per cent. It has made a return of 16.45 per cent, in US dollar terms, since launch in April 2018.