Tech bubble is tethered by serious profits

As technology shares soar, it's easy to make comparisons with the 1990s dotcom boom

(STAN HONDA / AFP )

Once bitten twice shy is probably an apt saying for many investors looking at technology shares.

At the end of the last century, all the investment talk was of a new type of firm, the dotcom. Investors were told by many so-called experts to forget about such business basics as turnover or even profit and to focus on these pioneers of the "new" economy. Yet it crumbled to dust, leaving investors nursing heavy losses.

But now, more than a decade later, tech is booming again, led by social media websites such as Facebook, Twitter and LinkedIn which are phenomenally popular with users. But should memories of the dotcom crash serve as a warning for investors?

Fears of a repeat performance seem to be having little effect on investor appetite, according to Barclays Stockbrokers, with the majority of its clients naming Apple and Google as their top two technology stocks in a recent poll.

"A decade on and it seems that technology is making a bit of a comeback," says Patrick Connolly of independent financial adviser AWD Chase de Vere. "It is the best performing investment sector over the past three years, returning an average of 63 per cent. This compares favourably with China which has produced 49 per cent, UK shares at 25 per cent, UK corporate bonds at 22 per cent and property at just 4 per cent,"

LinkedIn, a networking site for business professionals, was the first of its kind to go public in May; its shares doubled on the first day of trading on the US Stock Exchange. By day two, the company was valued at $9bn. Impending IPOs for game developer Zynga, Twitter and discount site Groupon are also causing a stir and could pave the way for the one everyone has been waiting for: social media giant Facebook, which has an estimated $100bn price tag.

Many are concerned that such high valuations are a sign that another technology bubble is forming, but experts say there are some key differences. In terms of sheer statistics, Jemma Jackson, from the Association of Investment Companies, highlights the contrast. She says: "At the end February 2000, the average tech investment company was on a premium of +3.41 per cent according to Morningstar (ie it was so popular that the market was prepared to pay more than the value of the underlying assets). At the end of June 2011, the average investment trust in this sector was on a discount of -8.7%, and this is pretty much in line with the broader industry average -8.8 per cent."

Moreover, the internet is infinitely different in terms of the sheer numbers that companies can reach, with 750 million Facebook users worldwide and more than 100 million users on LinkedIn. Unlike many of the internet companies that floated on the stock market in the 1990s with little more than an idea, many of today's big internet companies are already well established. Yet where investors must still be very careful is in determining how these companies can turn numbers into serious profit for investors.

"While there are large profitable technology companies, there are also those going to market that aren't yet making money. Web-based music services site Pandora Media, group-buying site Groupon and Chinese social networking site Renren have all filed to go public, but none as yet is generating a profit," says Mr Connolly.

Investors must also remember that internet users are a very fickle bunch; this is especially dangerous for the free sites that demand little or no customer loyalty. Abandoned by the bulk of its users, MySpace was recently sold for $35m (£22m), a fraction of the $580m Rupert Murdoch's News Corporation paid for it back in 2005.

There is also a danger that the hype surrounding a handful of leading web companies could persuade investors to punt on riskier firms with less potential to make money. Only those who manage to back the right horse can look forward to a healthy return, while others could be lumbered with their money tied up in companies worth only a fraction of their original price in a few years' time.

"Technology is an exciting and important sector in all types of investment portfolios," says Stephen Barber, who advises Selftrade on markets and economics. "But I think we need make the distinction between 'incubator' type tech businesses and those companies which lead the sector. After all, technology is a growth sector of global reach, profiting from domestic demand and the emerging economies."

Concerns over the profitability of social media stocks shouldn't necessarily steer investors away from the technology sector altogether. One of the most straightforward ways to get exposure to technology growth is through a fund holding a wide range of global technology stocks such as GLG Technology, Polar Capital, Axa Framlington Global Technology and Henderson Global Technology. Investors can be somewhat appeased that managers tend to bid for established and profitable companies such as Microsoft, Apple, Google, IBM, Samsung and Hewlett-Packard.

"A diversified technology fund is a worthy component of a portfolio. If you look at funds like GLG Technology, the two largest holdings are Apple and ARM, which manufactures components for it," says Danny Cox from IFA Hargreaves Lansdown. "A fund like this is the best way for most people to invest in technology."

Specific technology funds are still a specialist, higher risk area, so experts say that exposure should generally be kept to a maximum of 5 per cent. Those wary of investing in a single sector may prefer to stick to more broad-based equity funds and look for discerning fund managers. At Axa Framlington Select Opportunities, manager Nigel Thomas has 8.85 per cent of his £2.7bn fund in technology, which includes a large holding in Imagination Technologies.

Index trackers can also add diversification to a portfolio and are less risky than buying individual company shares. Legal & General offers an index tracking fund following a basket of 100 global technology shares, although it does charge a 1 per cent annual fee which may seem pricey for a passive investment vehicle. Investors may also feel more secure with a fund manager who can adapt to the rapid changes in the fortunes of tech companies.

"As none of us can accurately predict the future, obtaining your UK and overseas equity exposure, including small cap and value funds, using index funds gives a decent spread of equity holdings, including tech stocks. It also ensures that returns aren't eaten up by costs," says Jason Witcombe from IFA Evolve Planning.

Expert View

Danny Cox, Hargreaves Lansdown

'The technology sector has been in the spotlight, particularly Facebook and Twitter. Some investors are worried about frothy valuations, but taking a broader approach and looking at the technology sector as a whole, one sees a much more varied picture.

'The problem with the last tech boom was the numbers of companies with exaggerated valuations. You know when you are in a bubble when people in the pub tell you about tech funds they've bought. We are nowhere near that stage.'