Should tech funds be back on your radar?

Cloud computing sounds like something the Met Office might do to assess the risk of rain. Yet this is one of the technological innovations that fund managers in the sector hope will persuade us that technology is once again worth investing in.

Such fund managers have a reputation for talking up technologies that ultimately disappoint.

But it now seems that many of the innovations that were promised at the peak of the technology bubble a decade ago are finally becoming widely available.

For an insight into gaining exposure into the sector, read: How and where to invest in technology.

Cloud computing means that companies and other large users of technology will no longer need to have huge servers and IT departments networking all their users; instead, their computing will be done over the internet: the programs, data and interfaces they use will all be stored somewhere in the clouds - or ethernet.

Smartphones and tablets are transforming the way people use technology: mobiles are no longer just used for mundane things like phone calls but for accessing 'apps' that will do everything from tell you the time of the next bus to allowing you to set your television to record a programme.

Apple's (AAPL) iPad 2 is grabbing headlines but 130 other tablets were on show at the Las Vegas Consumer Electronics Show in January. And e-books are now out-selling conventional titles in many areas for Amazon, following the success of its Kindle e-reader.

The key question, however, is whether this latest round of technological innovation will translate into good returns for those who invest in it. The long-term record is not good. Nasdaq 100, the US technology index, and techMARK 100, the UK equivalent, stand at around half the level of a decade ago and funds have fared little better.

But there are signs that things are changing: the Bank of America/Merrill Lynch survey of investor attitudes shows that technology has been the biggest overweight sector among institutional investors for some months now. That is being reflected in the stock market: techMARK is up around 10% and the Nasdaq around 20% over the last year.

While retail investors still seem reluctant to take the plunge - deterred, perhaps, by the caution of their financial advisers - the average tech fund is now well ahead of funds in the UK all companies and global sectors over both one and three years. It may not be long before interest is awakened.

Ben Rogoff, manager of the Polar Capital Technology investment trust, is upbeat. "As a sector, we are two years into a bull market which should be multi-year in nature. The technology sector is enjoying a classic cyclical recovery," he says.

The fundamentals of tech firms, too, have undergone something of a transformation. They are much more soundly financed, with large amounts of cash on their balance sheets, regularly topped up with strong operating cashflow.

Rogoff estimates that around 10% of the market capitalisation of technology companies is in cash, making the earnings per share multiples look reasonable. "In aggregate, stocks are trading as cheaply as they have done at any time since the crisis," he says.

But there is a growing divergence between the shares of companies that investors think have the technologies of the future and those of firms that are being left behind.

Among the latter are some of the biggest names in the business. Jeremy Gleeson, manager of the Axa Framlington Global Technology fund, thinks the winners in the move towards mobile computing will not be traditional players like Nokia (NOK), Motorola, Dell (DELL) or Hewlett Packard (HPQ). Instead, he points to companies such as Apple, whose products are rapidly becoming the industry standard.

HTC, which is working with Google (GOOG), Android and Samsung (whose smartphones are popular), could also be among the winners.

"Over the last year, the successful technology companies have not necessarily been those which are to be the main providers of the future, unless they make acquisitions to reposition themselves."

That is being reflected in share prices. Overall, last year, the MSCI Global Technology index rose by around 12 to 14%, in line with equities as a whole.

"Drill down, and of the top 10 names in the index by market cap, only Apple contributed to that growth. Microsoft (MSFT), HP, Intel (INTC), Cisco (CSCO) - they all underperformed," says Gleeson.

Rogoff expects that to continue. "Tablets are going to crush PC vendors," he says, pointing to predictions that sales of these could reach 70 million this year.

"That is half the notebook market so PCs could easily go ex-growth. You do not want to be involved in computer-centric companies."

He also thinks that mobile computing will be a disruptive force. "People are saying they would rather pay 59p for Angry Birds (a mobile app) than £40 for a computer game." With games, you need Microsoft software and Intel processing to ensure compatibility; for an iPad or other tablet, compatibility is no longer an issue.

The emergence of these new technologies is also affecting valuations. Rogoff says that, excluding the old established giants, the US technology sector trades on a 20% premium. That will be justified if the companies producing new technologies grow more rapidly than the giants and tech companies.

But, with many new products either proving disappointing or taking far longer than expected to become profitable, in-depth product analysis of up- and-coming technologies is a key part of a tech fund manager's job.

Walter Price, manager of the RCM Technology investment trust, has an in-house team, Grassroots Research, which carries out consumer research related to companies and products its fund managers are interested in; Gleeson "tests to destruction" any new product, and when he "starts to see traction, that is when we start to make investments".

He adds: "It is a case of keeping on top of what is going on... Last year, we had 230 company meetings."

One of the things Gleeson is currently watching is 'caching' technology for mobile devices, similar to that which stores previously viewed pages on desktop computers. That would be useful in locations such as Olympic stadia, "when there are a lot of people in one location, all demanding bandwidth for their devices, but which does not have regular enough traffic to justify permanent capacity".

Price is interested in the kind of companies that will displace businesses such as Oracle () and SAP by offering cloud computing services. He cites firms such as Salesforce (CRM), which allows companies to choose their own apps for managing sales activities online. He thinks that companies are finally becoming sufficiently confident about security to feel comfortable about moving their processes across to the cloud.

Asia is becoming more important as a source of technology investment but, says Katie Potts, manager of the Herald investment trust, it is "challenging" to find companies with pricing power there. "They sell on price, not because of their intellectual property or technology."

Potts' trust is able to put seed capital into tech firms - it was one of the early investors in ARM Holdings (ARM) - and she says that the past few years have been good in this respect.

"There was a flight of capital from the sector, therefore valuations have been low and there have been a few takeover bids. That gave us the chance to support technology cheaply," she comments.

She thinks the lack of IPO (initial public offering) activity could be a good sign, suggesting the market is not expensive.

Fund managers expect mergers and acquisitions to increase, because companies are so cash-rich and because some of the bigger companies will want to buy new technologies or products to replace outdated systems.

"Larger companies, which have strong franchises, typically generate cash but don't necessarily have growth elements in place. They are increasingly likely to want to make acquisitions to inject a bit of growth into their businesses going forward," says Gleeson.

Last year, there was a "smattering" of deals, generally of large companies buying relatively small ones. "There has not yet been a wave of sizeable acquisitions, but that could come in the course of this year," he adds.

Indeed, there have already been a few: AOL (AOL) acquired Huffington Post, Intel bought McAfee, and Google tried to acquire Groupon, the deal-a-day website, but was turned down because it did not offer enough.

There are also signs that corporate customers of tech firms are getting over their reluctance to invest and are starting to upgrade their systems and to use some of the more innovative products and technologies, which should be good for sector demand.

That means technology funds look more interesting than they have for some time.

Many mainstream fund managers are also becoming more enthusiastic about technology shares, making it possible to get a healthy dollop of exposure without buying a dedicated technology fund.

Cockerill points out that Threadneedle American has Google, Apple and IBM (IBM) among its biggest holdings, while other funds such as Neptune Global Equity and Fidelity Global Focus also have significant exposure to technology.

Apple is the favourite share among most of the fund managers we spoke to, despite the fact that its soaring share price made it the world's second-largest company last year. Price points out that, even after their recent strong performance, high-growth companies such as Google and Apple still trade on just 15 times next year's earnings.

The UK's Apple equivalent is ARM Holdings, the microprocessor manufacturer standing on a quite eye-watering price/earnings ratio. But many investors think this is justified by the potential of its deal to supply Microsoft with chips for its Windows software.

Rogoff says that concern about its high valuation is misplaced: he believes it has a "massive opportunity" to get into new markets. "That is not in the 2011 numbers because it will not happen until 2012," he says.

Remember the crazy days of dial-up?

The sale of spectrum to mobile phone companies is a good illustration of the excesses of the technology boom and the more sober attitude now prevailing. Back in 2000, telecoms companies paid a staggering £22.5 billion for 3G (third generation) spectrum, yet the products to use it are only now becoming available.

The government is now auctioning 4G spectrum and analysts expect it to raise around a tenth of that figure, even though companies are now starting to profit from the technology.

The technology boom and bust is littered with cautionary tales: Freeserve - remember the days of dial-up, metered internet access? - and Baltimore Technologies - now a cash shell - stormed into the FTSE 100; fund managers fell over themselves to launch technology funds, and investors to buy them.

Those who still remember the likes of Framlington NetNet or Lincoln Internet Tollkeeper are likely to be the investors who lost their shirts when they merged or were closed down. At the peak of the tech boom, there were 23 unit trusts and 10 investment trusts.

But the millions who bought in at the peak of the frenzy ended up nursing huge losses: the average tech fund lost 85% of its value in the three years between March 2000 and 2003.

Advisers say the memory of that still colours retail investors' attitudes to tech, more than a decade on. Today, there are just seven unit trusts and three investment trusts specialising in technology.

This article was taken from the May 2011 issue of Money Observer.