Developments such as cloud computing and smartphones excite investors, but although fears of a new bubble are overblown, there are reasons to question the amount of innovation created by the Silicon Valley model, writes Daniel Ben-Ami.
?It is hard to imagine a sector signalling more of a mixed message than technology. At the same time as there are signs that could indicate a new bubble is inflating, others suggest that technology is an attractive investment.On the negative side there are plenty of indicators to raise the heartbeat of anyone who remembers the technology boom of the late 1990s. At the start of this year Goldman Sachs took a $500m (£307m) stake in Facebook, which gave the social networking site an implied valuation of $50 billion. A couple of months later Twitter's shares were valued at $7.7 billion. There was also the $42m financing of the Angry Birds mobile game and the success of the Microsoft Kinect for the Xbox becoming the fastest-selling consumer device ever.There are also signs which could be taken to show that fund managers are being caught up in the frenzy. Technology was the favourite sector in the March 2011 survey of global fund managers by Bank of America Merrill Lynch.
Despite these apparent warning signs there are contradictory signals showing that, at least in the sector as a whole, there are no signs of a bubble. In particular many well-known technology companies have large cash balances on their balance sheets. In that sense they are the antithesis of many technology firms of the 1990s, where the emphasis was on supposed future potential rather than current strength.Even in relation to social networking, the area where valuations could be most inflated, it is not possible to say for sure that a bubble has emerged. Since neither Facebook nor Twitter is a public company, many of their key financial metrics are not known. (Cover story continues below)
To assess the strength of the technology sector it is necessary to examine the investment case in more detail. In broad terms this rests on two planks. In addition to the claimed financial strength of the sector the case for technology rests on several developments: mobile computing, cloud computing and the growing importance of emerging economies.
Once this is done the experience of the 1990s "new economy" boom can be revisited with the benefit of hindsight. With over a decade since the peak of the market it should be easier to separate fact from fiction in relation to the claims made at the time. Although much of the debate was driven by hype there were some genuine insights that can be gleaned from the discussion.
It is perhaps no surprise that technology fund managers talk up the sector but, as the Merrill Lynch survey indicates, many non-specialists take a positive view. Mike Jennings, a global fund manager at Premier Asset Management, probably speaks for many when he describes the sector as "essentially undervalued" and argues that "there is no evidence whatsoever of a bubble in technology".
Specialist fund managers, many of whom lived through the agony and ecstasy of the 1990s bubble, are all too conscious of the painful experience of the past. They have thought carefully about how contemporary circumstances are fundamentally different.
Jeremy Gleeson, the manager of the Axa Framlington Global Technology fund, says: "The technology sector is a very different beast from 10 years ago. Back then it was about speculation and inflated expectations. Technology was going to be delivered in a succinct timeframe which would change our lives - and actually none of it did".
Technology firms suffered relatively little in the latest economic crisis because they had already gone through considerable pain a few years before. "The technology sector went through its credit crunch in the 2001-03 period," says Gleeson. Today the sector looks robust: "We've got real businesses here, with strong management teams and products that work." He points out that technology firms trade broadly in line with the S&P 500 yet they have particularly strong balance sheets.
However, it should be noted that the balance sheet strength of many technology firms is not an entirely positive development. This is something Premier's Jennings alludes to when he says: "They have incredibly strong balance sheets many of them - arguably far too strong." Rather than reinvesting, many firms are increasing dividend payments or engaging in share buybacks.
There is another way to read this phenomenon. As Ben Hunt argued in last week's Fund Strategy cover story the preference of many firms for hoarding cash, rather than investing, suggests a lack of confidence in the future. If anything this seems to be a problem for many companies in the sector rather than the opposite one of assuming the future will inevitably be rosy.
The other side of the case for technology investment is largely to do with innovation within the sector itself. Key technological developments are said to be bolstering the fortunes of firms within the sector.
Each fund manager has their own take on the topic but there are several themes that are common to most. The first, and probably the most obvious to the average consumer, is the explosion in mobile computing. Not only have phones become smarter but other devices, such as tablet computers, have become more ubiquitous. The growing popularity of these devices has also led to a huge increase in network traffic and subsequent investment.
Many companies, most notably Apple with its iPhones and iPads, are clear beneficiaries of this trend. Warren Tennant, a technology fund manager at Invesco, says: "We believe these are superior products in the markets to what else is being offered in the marketplace". In the short term at least it is difficult for other firms to catch up against such a substantial first mover advantage. There is also a sizeable "ecosystem" that has built up around Apple with its iTunes digital media player and legions of applications - or "apps".
Of course, where there are winners there are often losers too. Research In Motion, the Canadian company behind the BlackBerry smartphone, and Nokia, the Finnish mobile phone giant, are both suffering as a result of the rise of Apple. Companies involved in the traditional personal computer markets, such as Microsoft and HP, could also be casualties. Other firms, perhaps most notably Taiwan's HTC, are already on a determined counter-offensive against the Californian computing giant.
While smartphones have a high profile among consumers the trend towards cloud computing is aimed primarily at business users. There is no universally agreed definition of the term but it essentially refers to providing computing power online via an external network. So, for example, a firm could rent computer services via the cloud rather than building its own substantial infrastructure.
For many businesses this is an important trend. It means they can invest in new technology without the need for substantial upfront capital spending on such things as new servers. It can even mean substantial cost-cutting in IT departments. Axa's Gleeson says: "Cloud computing enables you to consolidate your infrastructure."
For technology companies themselves it has the additional advantage of making it much harder for others to pirate their products. Rather than selling sets of software that can be copied, their services are essentially rented over the web.
Another important trend for the sector, although not technological itself, is the rise of emerging economies. This means that there is a much larger market for technology-related products. Rather than being largely confined to the developed world there are substantial customers for such technology, both among individuals and businesses, in developing countries.
For Craig Mercer, a technology fund manager at Polar Capital, the combination of such trends marks a watershed. "There is a new cycle of technological innovation which is emerging and gaining traction," he says. Some large firms may be losers but many companies, particularly small and medium-sized firms, will be winners.
Axa's Gleeson even argues that a lot of the promises about technology made in the late 1990s and early this decade are coming true. Older users may remember the spectacularly unsuccessful Wap (Wireless Application Protocol) of a decade ago that prompted the common criticism that "Wap is crap". Yet in retrospect Wap was trying to do a decade ago what the iPhone, with its far superior technology, is achieving today. There was no problem in principle with using mobile phones for different types of data. The pitfall was that back then the technology was simply not good enough to achieve its goals.
There is no shortage of exciting developments within the IT sector - although it should be remembered that in general terms that was also true back in the 1990s. Many of them are already taking hold among consumers and businesses. This points to the potential for strong performance among fund managers who can manage the tricky task of picking the winners and avoiding the losers. But to assess the prospects for the sector as a whole it is necessary to look at the technology story more closely.
Some of the claims made during what became known as the TMT (technology, media and telecoms) bubble of the late 1990s look crazy in retrospect. A typical booster view quoted in Business Week in August 2000 stated that: "This is an epochal change in the history of production". The terminology varied but many followed this argument in heralding the emergence of a new economy, new paradigm or new era.
This in turn was supposed to have created the conditions for a new stockmarket, which had the potential to trend upwards for ever more into a golden future. The fact that the stockmarket kept on hitting new record highs for a prolonged period made this belief credible.
The starting point of the discussion was the amazing potential of the world wide web - the application of such features as websites and browsers to the infrastructure of the internet. It was in the late 1990s that the exciting potential of this technology captured the popular imagination. A little later mobile phones were added into the mix.
With the benefit of hindsight it is clear that the new technology was indeed astounding. It is hard to imagine a world before smartphones, iTunes and Skype let alone email or websites. In that sense the excitement surrounding the technology was justified.
The first problem was that it took far longer than anticipated for the technology to have widespread commercial applications. Although there was a lot of talk about e-commerce, relatively little was being sold over the internet at the time. Back in 2000 - after several years of hype - only 2% of British sales were conducted over the internet, according to the Office for National Statistics. For comparison, by 2009 the figure had reached 16.7% of non-financial sales alone.
Indeed, the challenge of commercialising the technology has not been entirely solved, even today. This is most clear in the media sector, where users generally expect content to be free but it costs money for firms to produce it.
A second problem was the speculative capital flowing round the world economy. Until the Asian financial crisis of 1997-98 much of it had found its way into East Asian financial markets. Subsequently many speculative investors, attracted by all the hype surrounding new technology, piled into technology companies and those listed on the Nasdaq in particular. Later on, after the 2000 TMT crash, much of this capital found its way into the American mortgage market. In this sense the TMT boom should, strictly speaking, be seen as a financial bubble developing in the technology market rather a technology bubble.
The final set of problems was in many respects a consequence of the first two. Theories of the "new paradigm" began to develop as a way of rationalising and explaining these developments.
In relation to the economy it was held that the new technology was leading to a golden era of productivity in the American economy. As a result it was widely held that the economy was likely to grow more strongly than ever before. The new technology had led to a permanently more dynamic economy.
From this premise it was taken by many to mean that, at least in the short or medium term, companies did not need to concern themselves with making profits. All the emphasis, it was said, should be on the potential for growth.
Looking back it is easy to sneer at such ideas. But many people, including influential business types and pundits, were captivated by them. However, there were also critics of the new economy hype.
Perhaps the most thorough critique of ideas of the new economy at the time came from Professor Robert Gordon of Northwestern University in Chicago. Through a detailed examination of the economic statistics he showed that there had been no acceleration in productivity growth in 99% of the economy. The only area where productivity had surged was in the production of computer hardware. It was only in the tiny proportion of the economy devoted to producing computers where productivity was transformed.
It should be noted that, more than a decade on, the debate about productivity growth and technology has not gone away. Tyler Cowen, a professor of economics at George Mason University in Washington DC, recently argued in an e-book, The Great Stagnation, that America's official statistics overstate economic and productivity growth. There are of course others who vehemently oppose his argument.
In any event there is good reason to question some of the broader claims about the new economy. Although information technology can benefit individuals and companies there are good grounds to be sceptical about the extent to which it boosts productivity growth. Technology alone is not sufficient to create a new economy.
Apart from the debate about productivity there is another important aspect of the new economy discussion that is often neglected. That is a fundamental shift in the way that innovation is generated within the American economy. This has coincided with the emergence of what has been called the New Economy Business Model (NEBM), with Silicon Valley as the prototype, from the 1970s onwards. With its high technology start-ups, venture capitalists and collaboration with universities it is a model that many others have tried to emulate.
Whereas technological innovation used to happen largely within large companies, it has become a more diffuse affair. The Old Economy Business Model (OEBM) was centred on the substantial research laboratories run by large firms. These included the likes of Bell, Du Pont, Eastman Kodak, General Electric and General Motors.
Today the emphasis has shifted towards small firms, which often end up being bought by larger ones, coming up with innovative ideas. This is a shift that Henry Chesbrough, a professor at the Haas School of Business at the University of California, Berkeley, has called the move from closed to open innovation.
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