How to make sure portfolios do not get entangled in a web of technology stocks

A couple of weeks ago this column mentioned a throwaway comment provided by a shrewd fund manager that: “There is no value in momentum [stocks] and no momentum in value [stocks].”

This issue has reared its head again, as this column has attended events hosted by

Schroders, Fidelity and M&G which have covered a range of topics from emerging markets to Asia to UK small caps, with a view to what will drive markets in 2018 and beyond.

Technology was a sector which came up again and again for three reasons

• It has done well the world over in 2017
• It looks expensive on many conventional metrics, such as price/earnings, price/book or enterprise value (debt-adjusted market capitalisation) multiple of profit
• There are signs in some areas that some names may just be running out of puff – Apple being the most glaring example

Even as the US market has set a number of new highs, using the S&P 500 and Dow Jones Industrials’ indices as benchmarks, Apple has lost 4% of its value since early September, despite the much-hyped launch of the iPhone 8 and iPhone X.

This is no cause for undue concern in itself, although a slight loss of share price momentum across all of the so-called FAANG stocks may give fans of tech (and momentum stocks more generally) some pause for thought. Facebook, Apple, Amazon, Netflix and Google (under the guise of its quoted parent Alphabet) have been a huge source of returns for dedicated tech funds but also more generalist US funds, so it would be a source of concern were they to suddenly roll over.

The FAANG stocks have offered a little less bite in the last three months

Change in share price	Facebook	Apple	Amazon.com	Netflix	Alphabet
1 month	0.7%	3.4%	2.2%	4.6%	4.8%
3 months	3.5%	3.3%	-6.1%	4.3%	-1.0%
6 months	18.1%	9.4%	7.5%	36.3%	12.5%
9 months	32.8%	30.9%	18.7%	39.9%	16.4%
12 months	28.9%	33.5%	16.4%	53.9%	18.3%

Source: Thomson Reuters Datastream

This is why understanding the different styles and drivers of the funds held in a well-balanced portfolio is crucial. Without this, there is a danger of false diversification – or in other words the portfolio looks diversified because it has a number of different holdings but in reality these funds are tilted towards similar industries, stocks or economic factors.

Crunch time at Apple

The slight pull-back in Apple shares should not be a source of panic (although a bigger one could be) – stocks cannot, do not go and should not go up in a straight line.

Moreover, the performance of Apple following the launch of its iPhone tenth-anniversary products is very typical of the stock’s history. It has tended to run up strongly going into a new release and then fall subject to profit taking afterwards, in a classic case of the market “buying on the rumour and selling on the fact.”

Apple’s shares have traditionally done poorly after a new product launch

				Movement in Apple share price
			Before launch		After launch
Announced	Product	Launched	6 months	3 months	3 months	6 months	12 months
09-Jan-07	iPhone 1	29-Jun-07	43.8%	30.2%	25.8%	63.7%	39.4%
09-Jun-08	iPhone 3G	11-Jul-08	-0.1%	-5.9%	-43.9%	-47.5%	-19.7%
07-Jun-10	iPhone 4	24-Jun-10	28.7%	17.3%	8.7%	20.3%	21.3%
12-Sep-12	iPhone 5	21-Sep-12	16.2%	69.9%	-25.8%	-35.3%	-33.2%
09-Sep-14	iPhone 6	19-Sep-14	29.1%	6.7%	14.1%	8.1%	15.8%
07-Sep-16	iPhone 7	16-Sep-16	8.4%	17.8%	0.5%	-7.8%	48.8%
12-Sep-17	iPhone 8	22-Sep-17	15.6%	10.6%
12-Sep-17	iPhone X	03-Nov-17	15.6%	10.6%
	AVERAGE		19.7%	19.6%	-3.5%	0.2%	12.1%

Source: Thomson Reuters Datastream, Apple

Talk of component order cutbacks of up to 50% for the iPhone8 and iPhone 8-Plus among Asia suppliers for November and December and availability issues for the glass panels used in the iPhone X are not helping sentiment toward Apple stock, so the company’s fourth-quarter results on 2 November should be illuminating.

It is nevertheless intriguing to see a slowdown in the rate of progress at the other FAANG stocks, too, especially Amazon – perhaps talk of the company splurging $5 billion on a second corporate HQ is giving investors pause for thought.

After all, the company’s first 20 years as a public entity (1997-2016) generated a grand total of $651 billion in sales but just $12 billion in operating profit and $11 billion in free cashflow.

Amazon needs to generate a lot more cash to truly justify its market capitalisation

Source: Amazon.com accounts

The good news is both profits and cash flow have started to grow – and so they must, to support Amazon’s $469 billion stock market valuation – but another big dollop of spending (and acquisitions) again raise the question of whether shareholders will ever get to see sustained cashflow (or bank their portion of it as dividends).

Asian angle

Such niggles may explain this slowdown in the FAANGs’ progress and also why the tech-laden NASDAQ Composite has not been setting quite as many new-all time highs as the Dow Jones Industrials or S&P 500. Looking at the sector on a relative basis, technology stopped outperforming in the USA during the summer.

Technology stopped outperforming in the USA over the summer

Source: Thomson Reuters Datastream

For all that, tech is still doing well globally, using the S&P 1200 indices as a guide.

Technology is still outperforming globally ...

Source: Thomson Reuters Datastream

That means another region must be taking up the baton and that area looks to be Asia, where the tech sector is still powering higher.

... with Asia a particularly strong contributor

Source: Thomson Reuters Datastream

Several themes are at work here, including:

• A massive year-on-year surge in Dynamic Random Access Memory (DRAM) silicon chips (spurred by ever-greater memory content in smartphones and tablets and digital cameras) and the dominance of Korea’s Samsung and SK Hynix in this area
• The market-leading position of Taiwan’s TSMC in the outsourced manufacture of silicon chips (or ‘foundry’ manufacturing)
• Asia’s strong position in supply of components to Apple for its smartphones and tablets (as well as Samsung’s own leading role in these fields), across passive components, casings, silicon chips and glass and LCD panels
• India’s well-established position as a hub for IT outsourcing
• The phenomenal rise of the internet and especially e-commerce in China, trends ridden by a trio of online giants, Baidu, Alibaba and Tencent. Over one billion Chinese now have a mobile phone and mobile payment transactions are rocketing as consumers use their portable devices to shop and play games (such as Tencent’s Honor of Kings as well as communicate via messaging services, such as Tencent’s WeChat.

Mobile payments are expected to keep booming in China

Source: www.statista.com/outlook/331/109/mobile-payments/united-states#marketstudy, Fidelity International

This helps to explain why just ten have generated 38% of the gain seen in the MSCI Emerging Markets index in 2017 – and seven of them are tech names (and that figure could even be eight, given that South Africa’s Naspers is the proud owner of a one-third stake in Tencent).

Technology stocks have been a huge driver of emerging market performance in 2017

	Sector	Index weighting	Performance *	Contribution to MSCI EM index performance	2017 P/E (x)
Tencent	Technology	5.0%	84.7%	9.2%	51.6 x
Alibaba	Technology	4.0%	104.1%	8.2%	64.7 x
Samsung Electronics	Technology	4.3%	51.4%	6.4%	12.4 x
TSMC	Technology	3.6%	35.6%	4.0%	16.6 x
Naspers	Consumer Discretionary	2.0%	56.7%	3.0%	129.8 x
Baidu	Technology	1.3%	50.7%	1.7%	42.0 x
SK Hynix	Technology	0.8%	95.9%	1.6%	9.5 x
Hon Hai Precision	Technology	1.1%	39.5%	1.5%	12.3 x
ICBC	Financials	1.2%	43.6%	1.4%	6.9 x
Ping An Insurance	Financials	0.8%	66.8%	1.3%	14.5 x
TOTAL		24.1%		38.3%

Source: Factset, M&G. In dollars from 1 January to 6 October 2017.

Funds poser

This fantastic performance from technology stocks means that momentum-driven or –heavily-tech-exposed pan-Asian or emerging market funds have done well in 2017. By contrast value-oriented fund managers have struggled to keep up.

This scenario presents both an opportunity and a challenge for their fund managers, as well as investors seeking the best risk-adjusted returns from their capital. If tech stocks keep powering ahead, certain EM funds will do a lot better than others and value-driven funds will struggle (yet again).

But the stunning run in tech names means that a lot of them look expensive, as that same performance table shows – and price/earnings multiples of 50 or 60 or more for the Chinese internet names in particular leave little margin for error, should there be a regulatory crackdown for example (something which is hardly unprecedented in the Middle Kingdom, no matter how careful entrepreneurs try to be).

Any slight slip in earnings momentum for whatever reason could leave to a slide in earnings forecasts, a derating of a stock and nasty share price tumble.

This again shows the importance of researching a fund manager’s style and a fund group’s overall philosophy before committing any capital, especially if investors own dedicated technology funds and then more generalist regional collectives – because there could be more portfolio overlap between these holdings than meets the eye.

This next table looks at the five best performing technology funds over the past five years and then lists their top ten holdings list, as disclosed by their most recent fact sheet publications.

Leading holdings of the five best performing technology equity funds over the past five years

Fund	Fidelity Global Technology	JP Morgan European Dynamic Technologies	Polar Capital Global Tech	Pictet Digital	Legal & General Global Tech Index
Class	W Acc (GBP)	A Dist (EUR)	I (GBP)	I dy (GBP)	I Acc
Fund size (£ m)	1,830.1	230.5	1,199.6	1,414.8	199.8
Annualised 5-year performance	26.2%	25.4%	25.2%	23.2%	22.7%
12-month yield	n/a	1.22%	n/a	n/a	1.06%
Ongoing charge	1.07%	1.82%	1.16%	1.21%	0.32%
Morningstar rating	*****	****	*****	*****	****
Top 10 Holdings
1	Alphabet A	ASML	Facebook A	Alphabet A	Apple
2	Apple	Nokia	Apple Call Option	Baidu ADR	Microsoft
3	Intel	Capgemini	Apple	Facebook A	Alphabet A
4	SAP	NXP Semiconductor	Tencent	Apple	Alphabet C
5	TSMC	Amadeus IT	Microsoft	Salesforce.com	Facebook A
6	Salesforce.com	STMicroelectronics	Alibaba	Alibaba ADR	Intel
7	Samsung Electronics	Atos	Alphabet C	Tencent	Cisco
8	Akamai	Logitech	Alphabet A	PayPal	TSMC
9	Alibaba	SAP	Amazon.com	Amazon.com	Oracle
10	Qualcomm	JPM Euro Liquidity	Applied Materials	AT&T	IBM

Source: Morningstar, for the Sector Equity Technology category. Where more than one class of fund features only the best performer is listed.

Investors can then compare those with the leading holdings of the five best-performing US equity funds over the last five years:

Leading holdings of the five best performing US equity funds over the past five years

Fund	Fidelity American Special Situations	JP Morgan US Select	Polar Capital North American	F&C North American	JP Morgan America Equity
Class	W Acc	I Net Acc	I USD Inc (GBP)	2 Acc	C Acc USD
Fund size (£ m)	1,330.0	193.3	1,622.4	103.1	1,151.9
Annualised 5-year performance	19.8%	19.7%	19.7%	19.5%	19.4%
12-month yield	0.70%	0.78%	n/a	0.91%	n/a
Ongoing charge	0.95%	0.60%	0.91%	0.81%	0.85%
Morningstar rating	****	*****	*****	****	****
Technology weighting	25.6%	23.5%	20.5%	21.6%	19.5%
Top 10 Holdings
1	Oracle	Apple	Alphabet C	Apple	Alphabet C
2	Berkshire Hathaway A	Alphabet A	Citigroup	JPMorgan Chase	Apple
3	Willis Towers Watson	Microsoft	Facebook A	Cisco	JPM US Dollar Liquidity X
4	NXP Semiconductor	United Health	Anthem	Boeing	Amazon.com
5	Verizon Communications	Walt Disney	Ametek	Home Depot	UnitedHealth
6	L3 Technologies	Pfizer	PepsiCo	Amgen	T. Rowe Price
7	Fidelity ILF - USD A Acc	Northrop Grumman	Visa A	UnitedHealth	Facebook A
8	Abbott Labs	Citigroup	Union Pacific	WalMart	AIG
9	BNY Mellon	Bank of America	Berkshire Hathaway B	Gilead Sciences	Capital One
10	Pfizer	Texas Instruments	S&P Global	Ford	Mastercard

Source: Morningstar, for the US Large-Cap Blend Equity category. Where more than one class of fund features only the best performer is listed.

This next table performs the same comparison with the five best-performing Asian equity funds over the last five years:

Leading holdings of the five best performing Asian equity funds over the past five years

Fund	Veritas Asian	Old Mutual Asia Pacific	Smith & Williamson Oriental Growth	Schroder Asian Total	Stewart Investors Asia Pacific Sustainability
Class	A GBP	R GBP Acc	B	C GBP Inc	B Acc GBP
Fund size (£ m)	627.9	233.1	12.6	2,510.2	428.5
Annualised 5-year performance	17.9%	18.0%	14.9%	14.6%	14.0%
12-month yield	0.61%	1.10%	0.99%	1.62%	0.74%
Ongoing charge	1.17%	1.00%	1.00%	1.32%	1.02%
Morningstar rating	*****	*****	*****	*****	*****
Technology weighting	34.2%	29.9%	38.0%	31.5%	23.5%
Top 10 Holdings
1	Samsung Electronics	Samsung Electronics	AIA	Alibaba ADR	Vitasoy
2	Ncsoft	Tencent	Samsung Electronics	Samsung Electronics	Tech Mahindra
3	Tencent	Emini S&P500	Indiabulls Housing Finance	TSMC	Standard Foods
4	Treasury Wine Estates	TSMC	Tencent	Tencent	Kotak Mahindra Bank
5	Samsonite	Alibaba ADR	CSL	Jardine Strategic	Marico
6	UBS	SK Hynix	Regis Resources	HDFC Bank	TSMC
7	Aristocrat Leisure	CSL	TSMC	AIA	Housing Development Finance
8	Brilliance China Automotive	Geely Automobile	Vakrangee	Hon Hai Precision	CSL
9	CSPC Pharmaceutical	DSB Group	Weichai Power	China Lodging	Ayala
10	AIA	Rio Tinto	Challenger	Swire Properties	Chrome Ate

Source: Morningstar, for the Asia Pacific ex-Japan Equity category. Where more than one class of fund features only the best performer is listed.

There is clearly some overlap so those investors who do have specific technology exposure may need to bear this in mind if and when they are looking for funds to fill any asset allocation to American or Asian equities.

Keep an eye on your chips

None of this is to say that the tech sector is primed to repeat the collapse of 2001-03, even if America’s NASDAQ has zoomed past its 2000 peak of 5,048 and the rise of the Chinese internet stocks may stir unpleasant memories of the Western tech, media and telecoms bubble of 1998-2000.

Given tech’s status as a momentum favourite it may take a major draining away of wider market liquidity to puncture tech this time around – so watch out for a sudden rash of new flotations, as that would potentially be a bad sign.

More fundamentally, this column’s favourite indicator is the Philadelphia Semiconductor (or SOX) index, which can be easily followed for free on the internet.

The SOX comprises 30 global makers and designers of silicon chips or the capital equipment needed to make them and a strong showing from the benchmark is usually a good sign for two reasons:

• Silicon chips are ubiquitous and can be found in everything from PCs, smartphones and tablets to fridges, cars and televisions. If silicon chip volumes and pricing are firm then the economy should be in decent health as the end products are in strong demand. Equally, the opposite applies.
• Chip stocks are highly operationally geared so small increases in sales can mean big changes in profits (up or down). This means they tend to be popular with momentum investors in particular, who will aggressively trade them when share prices and earnings estimates are rising and avoid them when the opposite holds true.

At the time of writing, the SOX is up by 38% on the year and showing no loss of drive, unlike the FAANGs, as it reaches new all-time highs near the 1,250 mark.

Philadelphia Semiconductor index is still making smooth progress

Source: Thomson Reuters Datastream

This bodes well for fans of tech and momentum alike but any roll-over here would be a bad sign for both camps, as a retreat in the SOX was an early indicator of trouble in technology and the economy more broadly ahead of the 2000-03 and 2007-09 equity bear markets.

Russ Mould, AJ Bell Investment Director