It’s back to the future for tech sector

Growth investors would be well-served to revisit challenges faced by the technology sector before its boom years of the 1990s.

Important parallels to the present day can be drawn, suggesting that a tech resurgence is on the horizon.

The 1980s weren’t kind to tech investors. Eerily similar to today, the turn of the decade into the 1990s saw the economy suffering from “macro issues,” with the United States mired in a lengthy slow-growth environment.

Then powerful secular trends appeared, spawning PCs, networking and the Internet. Those trends set the stage for an unprecedented tech revolution and considerable wealth for shareholders of the sector’s leading innovators.

When today’s innovations are seen as harbingers of a healthier economy, the sector is poised to offer comparable growth potential.

Since 2000, the S&P 500 has suffered two market meltdowns of roughly 50% — the bursting of the dot-com bubble in 2000-02 and the collapse of the hyperinflated U.S. housing market in 2007-08.

To this day, the tech-heavy Nasdaq Composite Index remains about 50% below its 2000 high.

Although equity markets and most tech stocks recovered smartly from 2008 lows, recent negative macro events have caused a spike in volatility. Investors remain skittish, having steadily withdrawn assets from U.S. equity mutual funds. The flight began in early 2010, only to accelerate in the past few months.

Growth funds, in particular, suffered the most significant outflows.

If you can look past the near term, there are plenty of reasons for optimism. The tech sector is experiencing powerful, transformative secular trends that have the ability to drive growth for companies positioned to participate. That will create the potential for wealth for prescient investors who identify long-term winners.

A few notable themes include:

Wireless connectivity and mobile computing. The desire for connectivity is driving global demand for both the hardware and software that enables this technology. The penetration of smart phones in the United States is approaching 50%, up from 25% just three years ago. Global penetration rates are about 15%, up from just 5% three years ago. The ever-increasing demand for wireless data looks likely to continue to rise exponentially, driven not just by smart phones but all mobile Internet devices, including netbooks and tablets. In turn, Internet traffic will accelerate at a hefty clip.

Internet retail and advertising. Internet retail sales are still less than 5% of total retail sales in the United States, but they are growing five times as fast as “bricks and mortar” retail sales. At the same time, Internet advertising, less than 10% of the total U.S. advertising pie, continues to grow appreciably faster than traditional advertising.

Virtualization and cloud computing. These forms of computing use the delivery of hosted services over the Internet, which may create unprecedented productivity gains. In an environment where controlling costs has never been more important, these services will create efficiencies that have a direct impact on corporate profitability.

Vast and largely untapped new markets. The emergence of millions of new consumers in emerging markets continues unabated and is likely to drive revenue growth for suppliers of consumer-oriented tech products and services. By 2030, it is estimated that there will be 700 million new consumers entering the middle class.

WHY IT IS DIFFERENT NOW

With such solid growth prospects, you would think that investors would have to pay a premium to participate, but many of these well-positioned companies trade at a significant discount.

Think back to the late 1990s. Investors didn’t hesitate to pay north of 40 to 50 times earnings for those companies with the best-perceived growth prospects. This “growth at any price” mentality exposed investors to excess valuation risk and many, ultimately, paid the price by 2000.

Today, the average large-cap-growth stock is priced at much more reasonable levels, about 14.5 times earnings, or about a 35% discount to the historical median over the past 15 years. Another key difference between then and now is that many of these companies have extremely healthy, cash-rich balance sheets, providing flexibility as business and economic conditions change.

Like the early 1990s, much noise is focused on today’s negatives, but investors would do well to learn a lesson from the past and consider the investment potential of the tech sector.

Lew Piantedosi is an equity portfolio manager for Eaton Vance Corp.

For archived columns, go to InvestmentNews.com/investmentstrategies.

Related Topics: Investment Strategies