This chapter covers various investment strategies specifically for a Technology allocation, building on the knowledge in this book. The strategies include:
Adding Value at the Sector Level
Adding Value at the Industry Level
Adding Value at the Security Level
Adding Value in a Technology Sector Downturn
Venture Capital
While the strategies presented here are by no means comprehensive, they'll provide a good starting point to construct a portfolio that can increase your likelihood of outperforming a benchmark. They should also help spur some investment strategy ideas of your own. After all, using this framework to discover information few others have discovered yet is what investing is all about.
Also, though these strategies focus solely on Technology, they are meant to be used as part of an overarching strategy for a portfolio managed against a broader benchmark. Some investors may choose to manage a portfolio only of Technology stocks (or any other single sector). But in our view, for individual investors, managing against a broader benchmark increases both risk management and outperformance opportunities.
Consistent with the top-down method, investors must first determine when it is appropriate to overweight or underweight the Technology sector relative to a broader portfolio benchmark. Some major factors contributing to this decision covered in depth in Chapter 3 are shown in Table 9.1. Each driver should be considered not on its own, but in combination with other relevant drivers and also larger macroeconomic conditions. Also, don't take this table to mean overweight decisions can be driven by the mere number of positive drivers (and the same is true in reverse with underweight decisions). There can be, at any one time, many more meaningful drivers than we have space to list here. And some drivers are just more important than others. Most importantly, macroeconomic drivers can swamp sector, industry, and sub-industry drivers.
Table 9.1. When To Over- and Underweight the Technology Sector
Driver/Factor | Bullish | Bearish |
|---|---|---|
Economic Environment | Expansion | Contraction |
IT Fixed Investment | Strong | Weak |
Consumer Spending | Strong | Weak |
Component Shipment Growth | Increasing | Decreasing |
Inflation | Slowing | Increasing |
Equity Supply | Falling | Increasing |
Technology Trends | Upgrade Cycles | |
US Dollar versus Foreign Currencies | Weak | Strong |
Tax Rates | Low or Falling | High or Increasing |
Style Leadership | Growth | Value |
Beta Leadership | High | Low |
Sentiment | Euphoric |
After the decision is made to overweight or underweight the sector, it's time to implement the strategy. The first step is determining the sector weight relative to your benchmark. The relative bet size should be proportional to your conviction. Mild conviction should translate to a more modest bet against the benchmark. The stronger your conviction, the bigger your bet. But a vital rule is to never make a bet so large that if you're wrong, you inflict irreparable damage to your portfolio's return versus the benchmark.
Next comes determining the actual investments. One method is directly mimicking the sector by buying all the sector's stocks in direct proportion to your under- or overweight. Obviously, this can be time consuming and costly—particularly for individual investors working with relatively smaller pools of money—depending on the number of stocks. An easier and likely cheaper method of mimicking the sector composition is buying Exchange Traded Funds (ETFs) or mutual funds. The following are some larger Technology ETFs:
Powershares QQQ Trust (Ticker = QQQQ)—Mimics NASDAQ Index
SPDR FD Technology (Ticker = XLK)
Vanguard Information Technology ETF (Ticker = VGT)
iShares DJ US Technology Sector (Ticker = IYW)
iShares S&P GSTI Technology (Ticker = IGM)
For more on available ETFs, visit www.ishares.com, www.sectorspdr.com, www.masterdata.com, or www.invescopowershares.com.
A more advanced strategy is making industry-level bets based on your top-down analysis. Each individual Technology industry falls in and out of favor periodically—no one area outperforms consistently over the long term. Each will lead or lag the overall sector and even the broader market to some degree, depending on factors like corporate IT spending, consumer spending, upgrade cycles, stages of the economic cycle, and global or regional growth in end markets. Your job is to determine how pronounced the degree of leading or lagging will be, when it's likeliest to happen, and whether it's likely to be profitable enough to make a bet.
The performance of the MSCI World Technology industries from 1995 to 2008 (Table 9.2) illustrates the variability of returns. Calendar year industry total returns are compared to the Technology sector total returns. Shaded regions highlight industry outperformance.
The disparity in performance can be explained by some of the fundamentals, themes, and drivers covered in this book. Notably:
Software significantly outperformed from 1995 to 1998, coinciding with multiple operating systems' upgrade cycles.
Communications Equipment outperformed from 1997 to 2000 as telecommunications carriers spent heavily building out networks to accommodate increasing demand for Internet access and wireless service.
Electronic Equipment, Instruments, & Components, along with Semiconductors & Semiconductor Equipment, both outperformed in the early stages of economic expansion (2003)—coinciding with demand for early stage components. Semiconductors & Semiconductor Equipment also outperformed following a bottoming book-to-bill ratio (2000 and 2001).
Ultimately, your decision to overweight or underweight an industry relative to the benchmark should jibe with your high-level portfolio drivers. Note: Always remember past performance is no guarantee of future performance. No set of rules works for all time and you should always analyze the entire situation before investing. The past is about understanding context and precedent for investing—it's not a roadmap for the future.
Like implementing a sector strategy, industries can be over- or underweighted by buying all the stocks in an industry proportionately, or by using ETFs or industry mutual funds. The following are some Technology industry ETFs:
iShares S&P GTSI Software (Ticker = IGV)
iShares S&P GTSI Semiconductor (Ticker = IGW)
iShares S&P GTSI Networking (Ticker = IGN)
A still more advanced strategy entails investing directly in individual firms. This strategy could be based on different opinions about corporate IT spending, consumer spending, end markets, regions, or some combination of all the above. For example, if you expect strong demand for PCs to drive up DRAM prices:
Focus on DRAM manufacturers operating at low utilization levels relative to peers, and avoid DRAM manufacturers operating at full capacity.
Focus on semiconductor equipment manufacturers with heavier exposure to the DRAM market, particularly those with established customers already operating at full capacity.
Focus on PC makers with the lowest cost structure relative to peers.
These are just a couple of examples, and they may not always prove correct—context matters. There are countless other potential tactics. As you become more familiar with specific Technology firms and their industries, you can eventually develop your own strategies. Always be vigilant for firm-specific issues that could cause a stock to act differently than you would expect in the context of your broader strategy. (And be sure to revisit Chapter 8 for how to select individual stocks.)
Most of this book focused on what drives the Technology sector and its industries forward. But what could cause a Technology boom to bust? No one sector or industry can outperform forever. The stock market eventually sniffs out all opportunities for excess returns, and sector leadership changes. So it's important to continually review all the drivers and question your high-level portfolio themes regularly.
Should your analysis lead you to believe the next 12 months will be a bad time for Technology stocks—because of the reasons detailed in Table 9.1 or something else—then it may be appropriate to either reduce or eliminate your weight in Technology firms or adopt a defensive position in your portfolio.
If you have lower or negative expectations for the sector, you can:
Get underweight by selling Technology stocks you already own.
Short individual securities or Technology ETFs in an attempt to capitalize on an expected decline.
While this should generally only be used on a short-term basis, you can purchase inverse ETFs such as the Proshares Ultra Short Technology (ticker: REW). These should rise in price if Technology stocks in general fall.
Purchase put options on Technology stocks or indexes.
Because of the potential leverage involved, strategies involving options (which can be used either to augment an over- or underweight) and margin should only be used by sophisticated investors. Shorting is also a more sophisticated strategy. Keep in mind, significantly deviating from your benchmark involves the significant risk of missing equity-like upside should you be wrong; and, therefore, should only take place when you have strong convictions you know something others do not.
Venture capital (VC) is the lifeblood of many nascent Tech companies. Its existence has been pivotal in shaping both the sector and underlying technologies used today, and it was one of the primary catalysts leading to the development of Silicon Valley. Giants like Intel and Google were backed by venture capital.
Investing in VC, however, involves different tools and analysis not covered in this book and is a very different process from buying stocks. VC firms are in the business of obtaining capital from investors to fund startups or fledgling companies, which in many cases are still in the idea stage. And most ideas don't pan out—research suggests only 1 out of 100 business plans that come in the door end up being funded.[121] But once an idea gets backing, the VC firm typically takes an active role in the development of the fledgling firm—with constant interaction with management and sometimes board representation.
Turning ideas into profit often takes years (if it happens at all), and during that period VC investments are generally more illiquid than common stocks. Profits are not typically realized until after the startup firm conducts an initial public offering or is acquired. In fact, additional funding is often required over the investment's time horizon.
Given the unique nature of VC, institutions are the primary investors—they're better equipped to handle the long-term time horizon, illiquidity, additional unique risks, and relatively high upfront costs. Typical investors include pensions, endowments, foundations, and corporations. However, it's not that difficult for high net worth individual investors to participate in VC funds.
We've covered a lot in these pages—Technology's basics, drivers, and common challenges. But remember, like all sectors, Technology is dynamic. The drivers and fundamentals vital today may not be tomorrow. But with the top-down method, you can apply a consistent framework to analyze the sector regardless of the current environment.
Chapter Recap
There are numerous ways to invest in the Technology sector. These include investing in ETFs, index or mutual funds, or buying the stocks themselves.
Investors can enhance returns by overweighting and underweighting Technology industries based on a variety of high-level drivers.
An advanced strategy involves making bets on individual firms like DRAM manufacturers operating at low utilization levels relative to peers.
Venture capital is the most direct method of investing in new technology firms. However, it is extremely risky and involves different tools and strategies than those required for stocks. It is also a market typically reserved for institutions.