Threadneedle: The outlook for US technology sector – January 2007

Investors have tended to be wary of the technology sector since the ‘dot com’ bust in the early part of this decade.

This lack of enthusiasm has contributed to the underperformance of the sector relative to the wider market in recent years. However, according to Cormac Weldon, Head of US equities at Threadneedle Investments, the outlook for the sector has been improving since August last year, and should continue to do so as we move into 2007. He said: “We had been overweight software, and underweight hardware and semiconductors for some time, but started closing the underweight in hardware during the second half of last year. We also continued to add to software stocks.”

Corporate earnings growth has been improving and, as a consequence, expenditure on new IT equipment is expected to be robust in 2007 as companies upgrade their existing infrastructure. Weldon sees Cisco and Microsoft as beneficiaries of this trend. “Cisco is the world’s largest networking company, and a direct play on an increasingly bandwidth constrained corporate sector. Microsoft’s much-anticipated ‘Vista’ software, which analysts suggest will be the most revolutionary new software since the company delivered Windows ’95 more than a decade ago, should also see demand from cash-rich corporates.”

Weldon also picked out Apple, a stock that has been held across a range of Threadneedle portfolios since 2005, as a likely outperformer this year. He suggests: “The staggering success of the iPod has created a whole new generation of Apple users, who tend to have strong brand loyalty and are now supporting Apple’s primary business – computers. The imminent launch of the iPhone will probably dominate attention in the short-term, but really it is growth in the computer division that will drive earnings this year.”

Another interesting area of technology, overlooked by a number of investors because it is regarded as too ‘niche’, is the video gaming sector. Nintendo and Sony have both recently launched new consoles, which has created a great deal of excitement in the sector. But, according to Weldon, it isn’t just the manufacturers of the hardware that stand to benefit. He said: “We like to look at product life cycles and how our portfolios can benefit from them. We have identified a number of software providers that are well placed to benefit from the success of the Nintendo Wii and Sony PlayStation III. In particular, we believe Activision, who make games for these consoles, stand to benefit disproportionately from this cycle, given the potential high margins popular titles can yield once the development costs are out of the way.”

Weldon continued: “We have also held Gamestop, the video games retailer, in our portfolios for some time. The company is the largest video game retailer in the US, which should help it secure a good supply of the new Wii console and all the software to play on it. And unlike most of its rivals, Gamestop sells used games as well as new ones, providing another dimension to its earnings stream.”