So what does the Technology investment universe look like? It depends on the benchmark, so choose carefully! The US Technology sector looks very different from Europe, Japan, and the Emerging Markets. Table 4.1 shows major domestic and international benchmark indexes and the percentage weight of each sector.

Sector weights show each sector's relative importance in driving overall index performance. While Technology is the smallest weight in the MSCI Europe, Australasia, Far East (EAFE) index, it's the largest weight in the S&P 500. Why does Technology have more relative weight in the US? One potential reason could be the US has historically had a freer economic environment with the necessary capital to cultivate new ideas and innovation. It's just tougher in many foreign developed nations to start a new business than it is in the US. This led to the establishment of Silicon Valley and produced many of the industry behemoths still in existence today.

But sector and regional weights aren't fixed and can change over time due to performance differences, additions and deletions of firms to the indexes, and a variety of other factors. For example, Financials, though still a sizeable sector, lost tremendous relative weight in most indexes through the 2008 bear market. Tech used to be much larger in most indexes prior to the 2000 to 2003 bear market. And for many decades, Industrials dominated. Sectors are constantly in flux.

Understanding how your benchmark and the sectors in it are structured is crucial to developing a portfolio because wide weight deviations can exist across regions and benchmarks. For example, in some countries, Technology is by far the largest sector; in others, it's barely a few percent. Table 4.2 shows the Technology sector's weight in selected countries. (In this example, the MSCI All Country World Index [ACWI] is used instead of the MSCI World to provide a wider scope.) Note: Tech in Finland more than triples the weight in the US. However, that weight is almost entirely concentrated in a single company: Nokia. Understanding how a sector is composed is vital—you don't want to think you're well diversified and find you're holding just one stock!

Not only can sector weights vary, but so can industry weights—sometimes greatly, depending on the chosen benchmark. Table 4.3 shows the weight of each Technology industry within each benchmark.

Understanding these weights allows you to not only properly weight your portfolio relative to your benchmark, but also effectively use your time by focusing on the most important components. For Technology, the largest industries are Software, Computers & Peripherals, Communications Equipment, and Semiconductor & Semiconductor Equipment—making up the majority of the weight in most benchmarks, and therefore the focus of much of this book.

Another distinguishing Technology characteristic is the industries are concentrated in relatively few, very large players. Table 4.4 shows the percentage weight of the 10 largest firms in each industry (using the MSCI World). With concentrations ranging from 68 to 100 percent of the industry, the largest firms truly dominate.

Firms that design, develop, and sell computers and related parts fall into the Computers & Peripherals industry. It's segmented further into two sub-industries:

Table 4.6 shows the 10 largest Computers & Peripherals firms globally. This list includes some computer heavyweights most investors are likely familiar with.

Computer Hardware Computer Hardware is the larger of the two sub-industries. Mostly original equipment manufacturers (OEMs), these firms produce computer products like servers and workstations. This is where you'll find branded PC manufacturers, like HP, Apple, and Dell. It's heavily concentrated in the US, with a respectable showing from Japan.

Computer Storage & Peripherals Firms in the Computer Storage & Peripherals sub-industry manufacture storage devices or peripherals, with most market cap weight in storage. EMC, NetApp, and Western Digital are dominant players in the storage market. EMC and NetApp are competitors, producing enterprise-level storage devices. Western Digital, though in the same market, doesn't compete directly with EMC and NetApp. Western Digital produces hard disk drives used within enterprise-level storage devices, but they're also used in PCs, consumer electronics, DVRs, etc.

Peripherals firms produce a variety of products (like computer mice, printers, monitors, etc.), but all for the same end market—computers.

Computers & Peripherals Operations Most hardware manufacturers operate similarly, with a few exceptions. All sell hardware products, but not every firm produces the components within. These are often sourced from third-party manufacturers and used to build final products. For PC manufacturers, this is true for virtually every component. The microprocessor, motherboard, memory, hard disk drive (HDD), and liquid crystal display (LCD) are all sourced from third parties. Each component is usually highly interchangeable with little differentiation in product functionality among brands.

Manufacturing in this industry varies. Some firms assemble their products wholly in-house. But many firms outsource a portion of manufacturing to third parties. Outsourced manufacturers, located primarily in Southeast Asia, build final products based on the OEM's design specifications. Both models have advantages and disadvantages. By outsourcing production, firms can reduce manufacturing costs—particularly helpful during periods of weak demand. However, keeping manufacturing in-house increases control over quality and production volumes.

Many products can also be customized with specific hardware and software during the assembly process. Firms doing this "customization" are known as value-added resellers (VARs).

Once assembled, hardware is sold through a few different channels: direct, distributors, and retail. Dell is well known for its direct model—selling directly to customers with no "middle man"—although the firm has recently pushed into retail. The enterprise market commonly uses both a direct sales force (for more complex and high-end products like mainframes and workstations) and distributors—one-stop shops for myriad technology-related products. The retail channel, stores like Best Buy or Office Max, is mostly for consumers.

Drivers The Computers & Peripherals industry is particularly economically sensitive. Businesses and consumers are simply less likely to make large ticket purchases when the economy's weak (as demonstrated in Figure 3.4), and sales rebound during periods of more robust growth. Emerging markets growth has become a particularly important driver. Businesses and consumers from these regions represent an increasingly large portion of global computer sales growth.

Just like software, upgrade cycles can be a significant driver. For example, new versions of Microsoft's Windows have typically led to increasing PC purchases, as do new generations of microprocessors. The combination of software- and hardware-driven upgrade cycles is sometimes referred to as "Wintel"—a combination of Windows and Intel. Structural changes can also spur upgrade cycles, like the transition from floppy disks to CD-ROM.

Demand for Internet access is another significant driver—particularly in emerging markets where penetration is still low. Many people own PCs solely for accessing the Internet, and devices such as netbooks have grown in popularity in emerging and developed markets alike.

A driver more related to storage than computers is the need for increasing amounts of digital data. More enterprises and consumers do business online, not to mention dramatic increases in video and multimedia content. Larger and more robust storage devices are required for storing all that rich data.

Earnings Drivers An important item to note: Top-line growth does not always translate into bottom-line growth. Sales and earnings can have disparate drivers. Earnings can be influenced by multiple factors—input prices (parts and labor) being one of the largest. PCs are built of the same basic components—many highly commoditized. So if there's global oversupply of LCD panels or memory, prices are likely to fall. This reduces the total cost of manufacturing a PC and can expand profit margins. And it can work the other way, too! If supply of certain components falls, prices rise and so do manufacturing costs. This shrinks profit margins.

As for labor, it's generally more expensive in developed markets than in emerging markets. Having a larger percentage of manufacturing in low-cost regions can help drive earnings, which is why many hardware manufacturers have shifted production to Southeast Asia.

Communications Equipment firms design, develop, and market com-munications equipment globally. This industry has just one sub-industry, also titled Communications Equipment. Table 4.7 lists the 10 largest Communications Equipment firms globally.

Communications Equipment Though the Communications Equip-ment industry and sub-industry are one and the same, they can be segmented into different categories—products manufactured for either the fixed-line or wireless market. Firms that focus mostly on fixed line, like industry giant Cisco Systems, produce equipment for networking and accessing the Internet (e.g., routers, switches, fiber optics).

The wireless market consists of two types of firms: infrastructure manufacturers and mobile handset manufacturers. While some do both, firms leveraged to the infrastructure market produce base transceiver stations and antennae that enable GSM and CDMA networks to function. Handset producers manufacture cell phones based on these same technologies. Nokia, Research in Motion, and Ericsson are leaders in different areas of the wireless market, which is largely dominated by non-US firms. However, many top mobile handset manufacturers are classified in other industries. For example, Samsung is a major handset producer, but is considered a Semiconductor firm, while Apple is classified under Computer Hardware. And some major handset producers, like LG Electronics, are in entirely different sectors.

Communications Equipment Operations From a manufacturing perspective, most Communications Equipment firms operate similarly to Computers & Peripherals firms. Companies outsource some or all of manufacturing and use third party component suppliers.

Distribution is similar to Computers & Peripherals as well. The enterprise market purchases equipment directly from suppliers or through third party distributors, and consumers use retail outlets. However, there are significant differences. In the PC supply chain, retail outlets are actual stores like Best Buy and Wal-Mart with broad product lines. But consumers buying handsets usually buy from retail stores owned by the service providers (like AT&T, Verizon, T-Mobile, etc.). These service providers typically subsidize mobile phone costs to attract new subscribers.

Also unique is mobile handset manufacturers can designate certain telecommunications firms as exclusive phone providers. For example, at the time of this writing, Apple iPhone users in the US can only get phone services through AT&T.

Drivers Drivers vary depending on the product, but like most Technology industries, economic growth is critically important. Upgrade cycles play a role as well. This is most obvious in the wireless space where every generation of network technology requires new investment in equipment. Much of the developed world has migrated to third generation (3G) networks, and the transition to 4G is already underway. Hence, increasing capital expenditures by telecom carriers can significantly influence growth.

Volumes and types of digital data carried over networks can also drive demand for infrastructure equipment. Fixed-line and wireless networks both have a finite amount of bandwidth—they become increasingly loaded as more users are added or more data are transferred. Demand is also rising for multimedia functionality and high-bandwidth content like video. To avoid congestion, network operators may add additional infrastructure or upgrade existing equipment.

When it comes to mobile handset demand, emerging markets are major contributors. The majority of unit phone purchases come from these regions where economic growth and rising incomes have placed wireless service within reach of consumers. This trend is likely to continue given these regions' low wireless penetration levels. In other words, relative to developed markets, there are fewer wireless subscribers as a percentage of the total population, which leaves more room for growth.

In developed markets, new subscribers are less of a growth driver because some developed markets have penetration levels above 100 percent—on average, each wireless customer has more than one phone. In these regions, growth is mostly driven by handset replacements and upgrades. Because of greater levels of wealth, demand for high-end handsets is concentrated in these regions.

Earnings Drivers As for earnings drivers, intense and growing competition puts downward pressure on earnings—for both infrastructure equipment and mobile handsets. In fact, the bidding process in wireless infrastructure is so competitive that supplying equipment for new network rollouts is often a drag on margins. Suppliers take an upfront hit in order to gain more profitable service and maintenance business down the road. This makes economies of scale critical—a favorable attribute for infrastructure and handset manufacturers alike.

Semiconductors & Semiconductor Equipment firms design, develop, and market both semiconductors and related production equipment. It's segmented into two sub-industries:

Table 4.8 shows the 10 largest Semiconductors & Semiconductor Equipment firms globally. Here, the largest player, Intel, simply swamps the other firms and is four times larger than its next-largest competitor.

Semiconductors Semiconductors is the larger of the two sub-industries.^[59] These firms manufacture integrated circuits for myriad purposes and end markets—microprocessors, memory, power amplifiers, converters, and many other forms. US firms make up over half of the Semiconductor weight (in the MSCI World Index), followed by Japan and the Netherlands. There is also a heavy concentration in Emerging Markets, particularly Korea and Taiwan.

Semiconductor Equipment Semiconductor Equipment is a much smaller sub-industry.^[61] There are fewer firms and the aggregate market cap and size of the total market is smaller. These firms manufacture specialized equipment used in the semiconductor production process—chip manufacturers are their primary customers. Mostly concentrated in the US, the industry leader is Applied Materials.

Semiconductors & Semiconductor Equipment Operations Producing chips on a large scale is highly capital intensive. Not only is research and development a significant input cost, but firms also need massive fabrication plants and expensive production equipment. This generally makes property, plant, and equipment (PP&E) one of the largest assets on a chip producer's balance sheet. It also means firms incur heavy depreciation expenses.

Semiconductor producers operate under multiple business models. There's the traditional, vertically integrated model, as well as fabless and fab-lite. Vertically integrated semiconductor firms, also known as integrated device manufacturers (IDMs), own and operate all of the fabrication plants producing their chips. They're responsible for building new facilities and maintaining and upgrading existing ones. This is the most capital intensive out of the three models, but it also provides the greatest control over quality and output.

In a completely fabless model, semiconductor firms outsource all manufacturing to third parties, referred to as foundries. This frees capital to be used in other areas, like research and development. It also relieves the burden of constantly upgrading to new technology and eliminates the impact of low utilization in periods of sluggish demand. However, it reduces control over quality and output, meaning fabless firms could potentially be unable to meet demand. This is why some companies have employed fab-lite models—a cross between the two where only a portion of manufacturing is outsourced to foundries.

Business models of semiconductor equipment firms don't differ much from those of machine manufacturers from other sectors and industries. Typically, these firms produce equipment subject to customer evaluation and testing cycles before release. However, due to the highly specialized nature of semiconductor equipment, testing cycles are longer. Because semiconductors are produced on an exceptionally small scale, precision and accuracy are of the utmost importance.

Sales and distribution are relatively straightforward. Equipment manufacturers primarily market and distribute products directly to chip producers. This includes IDMs, foundries, and firms performing testing and assembly services. However, semiconductor firms (mostly IDMs) ship products to customers in various stages of the hardware manufacturing chain. This includes third party distributors, contract manufacturers, foundries, and even original design manufacturers. There is minimal use of the retail market.

A variety of metrics are used to track company performance and industry fundamentals. One of the most common is the book-to-bill ratio (see Chapter 2). Capacity utilization is also tracked. This represents the percentage of total potential output currently in production. This information is reported quarterly for global chip manufacturers by the Semiconductor Industry Association (www.sia-online.org). This organization also issues monthly data on global sales of semiconductors.

Drivers Semiconductors are used in most modern electronics, with computers and mobile handsets representing almost two-thirds of consumption. Strong sales of PCs and mobile phones generally lead to higher unit shipments of semiconductors. And because these industries are economically sensitive, semiconductor demand is also greatly influenced by economic growth.

Demand for semiconductor equipment is largely dependent on semiconductor firms building new fabrication plants. These facilities require significant capital expenditures and are most likely to be built when economic conditions and demand for chips are strong. In fact, this industry is highly cyclical and one of the more economically sensitive in the Technology sector. Investment in new chip technologies and equipment often follows recessions and periods of prolonged underinvestment.

New generations of manufacturing technology can be important drivers for Semiconductor Equipment. For example, much of the industry has transitioned, or is in the process of doing so, to 300mm silicon wafers from the previous 200mm standard—requiring new specialized equipment compatible with the larger size. Feature sizes on chips are also getting smaller, which makes manufacturers invest in new equipment that can produce at smaller scales.

Earnings Drivers Like other areas of Technology, semiconductor prices suffer from deflation, which can negatively impact earnings. Newer, more advanced chips typically have higher price tags and margins than older versions—but this advantage is fleeting. Pretty quickly, the next version comes and pushes down prices on the previous generation, so manufacturers must constantly innovate to maintain earnings. This is particularly true for digital chips, which have become increasingly commoditized relative to analog on stiffer competition. They must be smaller, faster, and more efficient than previous generations to fetch a higher price.

Capacity utilization can also impact earnings. During periods of strong demand, manufacturers operate at much higher utilization rates. This reduces fixed costs as a percent of total output and helps drive margin expansion. Other factors influencing earnings include manufacturing models (e.g., fabless and/or fab-lite models described earlier), economies of scale, and improved productivity, to name a few.

Many firms that cannot be classified into other industries fall into Electronic Equipment, Instruments & Components, which is a bit of a grab bag of sub-industries. These firms design, develop, market, and distribute myriad forms of electronic equipment and components. Its four sub-industries include:

Table 4.9 shows the 10 largest Electronic Equipment, Instruments & Components firms globally. Here, there is heavy concentration in Japan rather than in the US.

Electronic Components Electronic Components is the largest sub-industry by aggregate market capitalization and total number of firms.^[62] Japan is again home to most firms in this market. These firms manufacture products like semiconductor photomasks, semiconductor packaging materials, chip capacitors, and LCD panels. The key commonality is all products are "components" built into devices higher up in the supply chain. Although mostly known for its cell phones, Kyocera is this sub-industry's leader.^[64]

Electronic Equipment & Instruments Electronic Equipment & Instruments is the second largest sub-industry by market capitalization.^[65] Mostly concentrated in Japan, these firms manufacture electronic pro-ducts for a variety of end markets. Hitachi is the largest of the group and a good example of the diversity of product lines. The firm manufactures hard disk drives, servers, LCD panels, semiconductors, nuclear power plants, elevators, circuit boards, and televisions, to name a few. It's truly a technology conglomerate. Such diversity of products and end markets is not uncommon among Japanese Technology firms.

Electronic Manufacturing Services The third largest sub-industry is Electronic Manufacturing Services,^[66] which is a more cohesive sub-industry than the previous two. These firms are all contract manufacturers enlisted primarily by Technology firms to build final end products. Tyco Electronics is this sub-industry's largest firm within the MSCI world. But if you include Emerging Markets, Taiwan's Hon Hai Precision Industry is the dominant global player. The firm produces PCs, mobile handsets, and various electronic devices for virtually all major Technology OEMs.

Technology Distributors Technology Distributors is the smallest sub-industry in the entire Technology sector by market capitalization.^[67] These firms act as middlemen in the technology supply chain, aggregating stockpiles of components, equipment, and systems that are resold to enterprise customers and retailers.

Operations and Drivers Because Electronic Equipment, Instruments & Components is a diverse, grab-bag industry, operations and drivers vary even within sub-industries and individual firms. Some Electronic Equipment & Instruments firms operate similarly to hardware manufacturers, while many are more similar to Industrials firms. For example, a significant portion of Hitachi's business is derived from power plants and industrial equipment like elevators, so growth is typically more dependent on physical infrastructure spending. However, its servers, LCD panels, and semiconductors are leveraged to IT spending—making it difficult to nail down any firm-wide drivers. Typically, discrete business lines will have unique drivers.

Electronic Manufacturing Services firms operate in several different ways. Some are contracted purely for manufacturing services—the product design is done by the OEM or contracting firm. Margins for these services are thin, so manufacturers try to take on as much volume as possible. Certain firms, however, operate with a more specialized business model, taking on smaller but more complex and higher margin projects. To try to improve profitability further, some firms also offer product design services. Drivers in this sub-industry also vary because firms are contracted by many different end markets, some outside of the Technology sector.

There are many types of IT services, but this industry includes firms offering non-manufacturing related services. The two sub-industries are:

Table 4.10 is a list of the 10 largest IT Services firms globally. Folks may presume some of these firms—like Visa, Mastercard, Paychex, and Western Union—are Financials firms, but, based on their services and product offering, they belong in the Technology sector.

Data Processing & Outsourced Services Data Processing & Outsourced Services is the larger of the two sub-industries.^[69] Most firms in this market process credit card transactions, payroll, money transfers, or other forms of data. Some firms offer services such as systems integration and business process outsourcing. Visa, Automatic Data Processing, and MasterCard are the largest players by market capitalization. This sub-industry is almost entirely concentrated in the US.

IT Consulting & Other Services IT Consulting & Other Services firms offer consulting, systems integration, and business process outsourcing. Outsourcing can include human resources services, network operations, or data center management. Accenture is this sub-industry's largest player, but this is another sub-industry with a heavy concentration in Emerging Markets—in this case India. And though IBM isn't classified in this sub-industry, it is the world's largest provider of IT services.

Operations and Drivers IT Services firms have two goals: expand geographically and reduce costs. Fierce competition gives those with cheaper and more widely available services an advantage. And keep in mind, these firms compete against larger and better-funded players in the hardware and software markets (like IBM). Because labor is one of the largest input costs, a larger percentage of workers in low-cost regions can improve margins. India has been a popular choice given its well-educated, English-speaking population.

The data-processing side of this industry is affected by diverse factors, depending on the end market. A sizeable portion of the market is leveraged to financial transactions, so increasing consumer and enterprise spending drives growth. Those involved in payroll processing, however, are driven by employment levels.

Internet Software & Services has one sub-industry of the same title. These firms use some form of online technology platform to generate revenue. This differs from online retailers, like Amazon, that use the Internet as a primary sales channel but also have physical infrastructure and inventory. Led by industry giant Google, Internet search is the dominant service offered. Google also represents over half of the industry's weight. Table 4.11 lists the seven dominant global players (the MSCI World Internet Software & Services Industry only consists of seven firms).

Operations and Drivers Most Internet search firms have two similar business lines—search and display (banner ads). Both are leveraged to advertising spending. In general, advertising budgets increase during periods of strong economic growth and are one of the first areas to be cut in periods of weak or declining growth. The number of aggregate Internet subscribers also plays a role, as does the quality of search results—the more relevant sponsored links are to the actual search term, the more likely a user will click through. Banner ads are less targeted than search, making them more sensitive to weak economic conditions and budget cutbacks.

Office Electronics is Technology's smallest industry by aggregate market capitalization and number of firms.^[72] Heavily concentrated in Japan, these firms produce electronic office equipment like copiers and printers. Canon is by far the largest player at over 60 percent of the industry's weight. Also, many computer hardware manufacturers compete in this market, though they're not classified in this industry. Table 4.12 lists the six largest global Office Electronics firms (the MSCI World Office Electronics Industry only consists of six firms).

Operations and Drivers These firms sell office equipment to businesses and consumers, though the top two players, Canon and Ricoh, have significant exposure to digital cameras—a market almost entirely driven by consumer spending. Operations are similar to other hardware and equipment manufacturers with one notable difference: Following the sale of a copier or printer, these firms generate recurring revenue through sales of highly profitable supplies (e.g., ink and toner). Demand for this equipment has largely been driven by generational transitions like from print-only to multi-function devices, and from black and white to color.

Chapter Recap

• The Software industry includes producers of system, application, and home entertainment software. Most firms generate sales from upfront licensing fees and charge customers for ongoing support and maintenance. Hardware demand and upgrade cycles are two of the primary drivers.

• The Computers & Peripherals industry includes hardware, storage, and peripheral manufacturers. Many companies in this market source components from third party manufacturers, which are built into final products. Drivers include strong economic growth, upgrade cycles, Internet penetration, and increasing digital data.

• Companies in the Communications Equipment industry produce equipment for fixed-line and wireless networks, as well as mobile handsets. Upgrade cycles, demand for multimedia content, and demographics are all drivers.

• Semiconductors & Semiconductor Equipment companies manufacture chips and related production equipment. Operations are carried out through vertically integrated, fab-lite, and fabless business models. Drivers include PC and mobile handset demand, innovation, new production technology, and economic growth.

• Electronic Equipment, Instruments & Components companies offer a wide range of products and services. As such, operations and drivers vary depending on the sub-industry, end markets, and company in question.

• Companies in the IT Services industry provide data processing, consulting, systems integration, and business process outsourcing. Global scale and offshore operations are important attributes.

• Internet Software & Services is leveraged to the Internet search market, with advertising spending as the single largest driver.

• Office Electronics is a small industry with majority of the weight concentrated in one company. These firms sell upfront equipment and generate recurring revenue from supplies.