Science and technology stocks have been one of the most challenging market sectors for more than six years, shunned by many investors after the excesses of 2000-01. Fund managers maintain the worst is over but debate the timing of the recovery.

One who remains cautious is Robert McWhirter, president of Toronto-based Selective Asset Management Inc. and manager of Northwest Specialty Innovation Fund, offered by Toronto-based Northwest Mutual Funds Inc. In the past year, the fund has held up to 60% in cash but has also gone as low as 6%. Lately, cash has been around 45%.

He uses a blend of bottom-up stock-picking and quantitative investing, relying on a 12-factor model that screens stocks for earnings estimates and positive or negative revisions.

“We use technical analysis tools to help us decide when to put the money to work and when to take the money off the table,” McWhirter says.

“The key is protecting your equity,” he adds, noting the signals were cautionary at the end of July. “If storm clouds are on the horizon, we move to the sidelines.”

One signal came from a tool that measures momentum of the benchmark Nasdaq index, suggesting the Nasdaq was running out of steam. There was also a strong “buy” signal for government bonds. “The signals said, ‘Reduce risk, sell high-beta Nasdaq stocks and buy bonds’,” he says. “Our guess is we will have a sideways to downward pattern.”

McWhirter admits the market has not moved “other than sideways” for six-and-a-half years. “We are fairly close to coming out of that trend,” he says, “and are starting to approach a long-term bullish period that could last two or three years.”

Why is the market changing? In two words: superior growth.

McWhirter argues the typical company in the Standard & Poor’s 500 composite index will see 8% earnings growth in the next 12 months. In contrast, bellwether tech companies such as Cisco Systems Inc. are expected to double that level of growth.

“Earnings are continuing to grow, and price/earnings multiples are coming down to the point at which some large-caps are trading at the same level as the market,” he adds. “So, you go, ‘Hey, these sleepy tech stocks may be an area of opportunity’.”

Running a 50-name domestic fund, McWhirter favours Canadian small-cap firms, which may account for the fund’s recent reclassification to the Canadian small-/mid-cap fund category.

One favourite is Allen-Vanguard Corp., a leading manufacturer of counterterrorism equipment systems. Allen-Vanguard supplies clients such as the RCMP, FBI, U.S. Secret Service and the U.S. army with its robotic bomb-disposal systems. the company also has electronics technology that has been used at suspected biological warfare facilities and to jam roadside bombs in war zones such as Iraq.

McWhirter bought Allen-Vanguard in late 2002 during the initial public offering and held it through the roller-coaster ride that ensued. The stock bottomed at $1 a share in March 2006, but rapid earnings growth turned it around. It recently traded at $9.60 a share, just shy of his $10-a-share target.

Another favourite is Martinrea International Inc., which manufactures assemblies, modules and fluid-management systems, mainly for the automotive industry. In a tough environment, it has a return on equity of 11.6%. Its stock price has declined slightly since McWhirter acquired it this past spring at about $17 a share. Still, he points to its anticipated 2008 earnings growth of 27% and its 12 times P/E multiple for fiscal 2008. His 12-month target is $20 a share.



The tech sector rebound is already here, according to Jeff Rottinghaus, a portfolio manager at Baltimore-based T. Rowe Price & Associates who oversees TD Science and Technology Fund for TD Mutual Funds Inc.

“We feel pretty good about the outlook for technology and felt that way coming into 2007,” he says. “Technology is driven by cycles. You can tie enterprise spending to the macroeconomic cycle, but what’s more important in technology is the product cycle.”

For example, he says, Microsoft Corp.’s new Vista operating system will drive a significant shift toward PC upgrades, which will become more apparent later this year and in 2008. As well, three new platforms in the video-game sector appeared late last year: the Xbox 360, the Sony PlayStation 3 and the Nintendo Wii. That will result in a multi-year video-game cycle.

@page_break@Rottinghaus agrees tech stocks have proven to be a challenge, largely because the market has been working off the excesses of the past. He argues, however, that valuations are now at more attractive levels. This is especially true of large-caps such as Microsoft, which is trading at about 14 times 2008 earnings, vs 15.5 times for the broader market.

“Microsoft has a higher growth rate than the market, but is trading at a discount [to the market],” he says.

Another reason for his optimism is tech stocks did well in the first half of the year. “This is only the second year of the past eight in which technology outperformed the market in the first half of the year,” says Rottinghaus. “And technology has outperformed the market in the second half in six of the past seven years. We think it will be seven out of eight at the end of this year. There are opportunities driven by new product cycles.”

Fully invested, Rottinghaus is running a 66-name fund about two-thirds invested in the U.S., with the balance in international markets. By sector, 20% is in semiconductors, 20% in hardware, 18% in software, 13% in communications equipment, 15% in manufacturing services, 10% in Internet-related and small holdings in telecom services.

Rottinghaus believes a PC upgrade cycle has begun. “PCs typically are upgraded every three years,” he says. “Most corporations lease them for 30 months.”

The last cycle began in 2004, so he believes the next is underway. It will be helped by the fact that there is much less penetration in emerging markets, which are growing at about 18%-21% a year.

Holdings he believes will capture the trend include Microsoft, and PC makers Dell Corp. and Hewlett-Packard Co. Rottinghaus has also gone offshore and invested in Hon Hai Precision Industry Co. The Taiwan-based contract electronics firm makes a range of products, from Apple iPods to PCs. “Its plants are in China and India, so it has a low-cost advantage,” he says. The firm has seen 35% top-line growth annually over the past six years. “It’s a well-managed business.”

Acquired two years ago at 160 Taiwan dollars, it recently traded at about T$268 a share. His 12-month target is above T$300 a share.

Another favourite is Google Inc., which Rottinghaus has owned since its IPO three years ago. He has seen it rise to about US$515 a share from US$85. Google has started to expand its reach and recently bought YouTube Inc., a popular video site. He notes Google’s earnings are growing by more than 30% a year. His 12-month target is US$600 a share.



Equally bullish is Tony Genua, co-manager of AGF Global Technology Class and senior vice president and research director at Toronto-based AGF Funds Inc.

“Innovation will result in new products and services for technology companies,” says Genua. “More product innovation today is driven by consumer demand.”

He notes increased demand from corporate users: “They have been cautious in capital expenditures, resulting in pent-up demand for products and services.”

Tech companies’ revenue growth averaged more than 10% a year in the 1960s through the 1990s and around 6% this decade. He says the current level will increase for two reasons: corporate balance sheets are in excellent shape and companies know tech spending will result in productivity gains. “In the second quarter of 2007, 73% of technology stocks met or exceeded revenue growth expectations,” he says.

Running a concentrated 34-name fund, Genua and co-manager Coulter Wright have allocated about 35% to communications equipment firms, 16% to Internet software and services, 13% cto omputer storage and peripherals, 12% to systems software, with small holdings in semiconductors.

A top holding is Sierra Wireless Inc., which makes wireless communications cards for PCs. It is seeing rapid growth because of major clients such as Verizon Communications Inc. and AT&T Inc. Bought in late 2006 at about $10 a share, Sierra recently traded at $21.15 a share. Genua says it has 50% upside in the next year to 19 months. IE