For five long years the science and technology sector has been struggling to shake off the excesses of the 2000-01 market bubble. The malaise still lingers in the sector, which was hit this spring by fears of further interest rate hikes and earnings downgrades.

Fund managers have mixed views about the short term. Some are bullish while others are more cautious.

“In terms of capacity, it has taken years for companies to return to a proper balance between supply and demand,” says Howard Sutton, manager of Tera Capital Global Innovation Fund and president of Tera Capital Corp. in Toronto.

“And a lot of companies that were funded during the ‘hype years’ didn’t have sustainable business models and died. Or they were acquired on the cheap-cheap,” he adds. “There’s been an entire cleansing, like water going over a waterfall with eddies at the bottom. It takes awhile for the water to return to a normal flow.”

Sutton says the current investment environment is healthier: “Five years ago, you threw a dart at the dartboard and it didn’t matter if it was a good company or a bad one. It was just money flows chasing, in many cases, ridiculous situations and pumping them up to insane valuations.”

By contrast, he adds, valuations are now in a more normal range and stocks more attractive: “If you invest in a good company performing well in a competitive environment, with positive cash flow and a reasonable valuation, you will do well.”

The possibility of more rate hikes in the U.S. is a concern, says Sutton, who notes the sector has been driven by consumer spending, which could slow down. “With people spending less, that will impact the tech sector,” he says. “We’ve already seen a slowdown in the growth of [personal computers].” Nevertheless, he remains bullish, although he is highly selective and sensitive to valuations.

Running a concentrated fund of 15 names that are primarily Canadian (about 15% is in international stocks), Sutton focuses on smaller companies. “We believe we can bring more value to our clients and the companies we’re investing in,” he says, adding that the investments’ market cap ranges from $8 million to $300 million.

Sutton looks for firms with strong management and intellectual property or patents that provide barriers to entry to competitors. One of his favourite names is Zarlink Semiconductor Inc. A former divi-sion of Mitel Corp., the firm makes semiconductors for the communication networking equipment industry, as well as so-called “ultra-low power” chip sets used in medical applications such as pacemakers. After a rough patch and a management turnaround, the firm has stabilized. “We are seeing flickers of growth in its product line,” Sutton says, referring to the chip-set division. “When the market starts to believe Zarlink can grow, it will give a premium to the stock.”

He adds that Zarlink trades at nine times earnings, when cash is excluded. Bought in August 2005 at $1.60 a share, the stock recently traded at $2.50. Sutton has a target of $5 a share within 24 months.

Another top holding is Neptune Technologies & Bioresources Inc., listed on the TSX Venture Ex-change. The marine-sciences firm focuses on the medical benefits of oil extracted from krill, tiny crustaceans found in oceans. Clinical studies have demonstrated that krill oil, in tandem with statins such as Lipitor, increase the ratio of high-density lipoprotein (good cholesterol) to low-density lipoprotein (bad cholesterol). Although Neptune already sells its product in health-food stores, “the big golden egg is the potential for pharmaceutical sales,” says Sutton. “That’s not to say Neptune is going to be worth US$1.5 billion. It just shows what the opportunity is.”

Purchased last November at 76¢ a share, the stock recently traded around $2.70. Sutton has a 24-month target of $5 a share.



Unlike the broader indices that have recovered from the spring interest rate shocks, the Nasdaq composite index has not rebounded to the same degree for several reasons, says Robert McWhirter, manager of Northwest Specialty Innovations Fund and president of Toronto-based Selective Asset Management Inc.

“There are concerns about economic growth and specific earnings announcements from companies such as Intel Corp. and Dell Inc.,” he says. “In many cases, they’ve said they are not making a lot of money. Forward guidance looks like tough sledding, especially in the PC space. Someone has described the current background as ‘profitless prosperity’.”

@page_break@On a macroeconomic basis, the technology sector has reacted more adversely than other sectors because of its high “beta” characteristics He explains: “As the economy improves, the tech sector does well. When the opposite happens, the sector slows down more than the general economy.”

Strategically, McWhirter uses a blend of quantitative investing in the 60-name fund, which relies on a 12-factor model that screens earnings estimates and subsequent positive or negative revisions, and fundamental bottom-up stock-picking.

Lately, his quantitative models had been urging caution. As a result, he had raised cash to about 45%, but that was dropping as the signals became more positive in early August. “There are glimmers of hope,” he says, “and our technical analysis implies that North American markets may rise for the next five to eight weeks.”

Of note is the fact that 10-year U.S. bonds are yielding almost 5%. “From a technical analysis perspective, as yields drop to around 4.94% or lower,” he says, “people will become more interested in stocks. We’re expecting a rise for the next five to eight weeks, and then a market pullback in October, and potentially a rebound at the end of the year.”

McWhirter cites Virtek Vision International Inc. as a core holding. The engineering firm supplies laser-based technology used to cut carbon-fibre materials for jet engines, as well as sheet-metal roofing systems. Among its clients are numerous subcontractors to Boeing Corp. Bought in late 2005 at an average cost of $1.04 share, the stock was recently $1.30. McWhirter has a 12-month target of $1.70 a share.

Another favourite is Ceramic Protection Corp., which makes inserts for bulletproof vests used by the military; the company has recently acquired a division that makes vests used by the police. The firm has a new venture that manufactures inserts for police-car doors, which are installed at Ford Motor Co. assembly plants.

“Sales have been modest, but over time are expected to grow,” says McWhirter, who has traded in and out of the stock for the past two years. The average cost is $24.30 a share, although it recently traded at $22.60. Nevertheless, he is bullish and has a $27 target within 12 months: “It’s a reasonable price because it has a price/earnings multiple of 10 for fiscal 2007.”



Earnings disappointments, concerns about economic growth in 2007 and recent investigations by the U.S. Securities and Exchange Commission into options practices of a number of technology firms means it is no wonder there has been a “buyer’s strike,” says Ben Rogoff.

But the trend could be reversed, says the senior portfolio manager at London-based Polar Capital Partners Ltd. Rogoff is on the team that oversees Mackenzie Universal World Science & Technology Capital Class Fund.

“Just as the summer is a difficult time for tech stocks, the fourth quarter is a fabulous time,” Rogoff says. The early summer sell-off pushed institutional investors into lowering their technology exposure to an underweighted position — to about 17% from roughly 20% of their portfolios. By the fall, Rogoff expects them to come back, as the uncertainty diminishes.

From a longer-term view, he is bullish for several reasons. First, he does not believe the U.S. economy will slip into recession. Second, from a valuation perspective, the sector has dropped significantly. During the 2000 bubble, Rogoff notes, the average technology stock traded at three times the market multiple. Today, it trades at 1.2 times, on a forward P/E basis. The long-term average since 1978 has been 1.4.

“The lowest level has been 1.1 times in the recession of 1990. This is the key: if we are right on our base case, there are not matters of downside in terms of relative valuation,” he says, adding that multiples have been compressed despite decent earnings growth.

“To be a bull today, you have to believe tech-stock valuations are no longer compressing,” says Rogoff. “You don’t have to believe they will expand. We are already trading at a decent discount to the long-term average.”

Working within an eight-person team led by Brian Ashford-Russell, Rogoff helps run a 130-name fund. About 50% is invested in the U.S., 25% in Asia and Japan, and 18% in Europe; 7% is in cash.

“We believe there are a disproportionate number of opportunities in Asia and Japan that are not well followed. The U.S. is a very well-researched market,” he says.

One of the top names is Dena Co. Ltd. Based in Japan, it is similar to eBay Inc., but runs auction and shopping sites over cellular telephones. Thanks to the popularity of so-called “3-G” (third-generation) phones, users can conduct auctions away from home. Acquired in late 2005 at about 275,000 yen, it is now 305,000 yen. “It’s not a cheap stock,” he admits, noting that it trades at a P/E of 70. “But it is growing very rapidly.” Rogoff says the stock has a 40% to 50% upside over the next 12 to 24 months.

Another favourite is Google Inc., the Internet search engine firm. “This company is unfettered by ‘old stuff’ and is benefiting from more time and money being spent online,” says Rogoff.

Bought a year ago at about US$280 a share, the stock was recently at US$368. On a forward-year basis, it is trading at 28 times earnings, or double the Standard & Poor’s 500 composite. “It’s trading at a premium to the market. But last year it grew earnings 127%, this year 70% and next year 30%,” he says. “It’s a slowing growth story, but the multiple reflects that. This is a core holding.” IE