Now that their love affair with technology seems to be over, are investors ready to embrace another sector in the same way?
History says there's a decent chance it will happen.
In the 1990s, the growth of the Internet, the proliferation of computers and the so-called Y2K bug combined to make technology king on Wall Street. The decade before that, pharmaceuticals and biotechnology were the hot-ticket equities, and in the 1970s, it was the energy sector.
The technology bubble popped in 2000, as blue-chip technology companies such as Oracle, Cisco and Microsoft plunged, and fledgling dotcom companies nose-dived-sometimes into oblivion. This year, investors seem almost shell- shocked. Day-to-day news moves the market more than anything else does, it seems.
But if a buying momentum does start to build, in which direction could it go? What sector might dominate the first decade of the 21st century?
Financial Advisor posed this question to six fund managers who have had recent success in staying one step ahead of Wall Street. Most feel there are indeed sectors that could break out in a dramatic fashion. And even though their picks differ, there is a commonality to all of them: technology.
Yes, the sector that many have left for dead could actually be responsible for another buying spree this decade. But in a more subtle way.
This is a decade, they say, where the ripple effects of the technology revolution are going to become glaringly obvious in other industrial sectors. In the laboratories of biotechnology companies, for example. Or the weapons and equipment used by the military.
One manager thinks the most obvious fallout from the technology boom will be a sky-high demand for electrical power. Another sees the revolution in communications benefiting another industry: telecommunications companies that own the "pipes" through which all electronic talk must pass.
Yet another feels sector-picking is a waste of time and prefers evaluating stocks company by company.
Most of the fund managers also think the pure technology sector is far from dried up. Nancy Tengler, of Fremont New Era Value Fund, says her company now considers companies such as Cisco, Intel, Microsoft and even General Electric as value plays.
"Typically, when this happens, you're approaching a bottom," she says.
Adds Gene Sit, of Sit Mutual Funds, "We're probably going through a digestive period right now ... The babies have been thrown out with the bath water."
Next are what they and other fund managers believe are the potential hot sectors for this decade.
As investors sift through the wreckage of the once high-flying technology sector, Weitz Hickory Fund's Rick Lawson is getting down to basics. You might say his credo is, "It's the bandwidth, stupid."
For Lawson, continued growth in the demand for faster and easier communications is a certainty. He's got his eye on telecommunications service providers who are building fiber-optic and wireless networks so people and businesses can yak away when and wherever they want.
"Just think about the amount of information that is going to be transmitted long distances," he says. "It seems to me that it's inevitable that's going to grow very rapidly for a very long time."
How communications needs are satisfied, and for what purpose, are secondary. Underlying everything, he says, is the need for bandwidth-the "pipes" that carry communications traffic over long distances. The expected growth, deregulation and the likelihood that technology costs will drop all point to a robust industry, he says.
That's why he likes companies such as Qwest Communications International, Williams Communications Group, Global Crossing and Level 3 Communications-service companies that continue to expand their fiber-optic networks. Deregulation has opened the door for these relative newcomers, while older players such as AT&T, Sprint and Verizon struggle to hold market share and upgrade aging networks.
"I'm not saying these companies are all dead, because they aren't," he says. "But when you go through a period of big change, often the new guys who are taking business away from the old incumbents end up doing the best."
In the cellular industry, he's most optimistic about companies that are moving beyond hotly contested urban markets into outlying rural and low-density suburban markets. "I think in the long run, that will prove to be important," he says.
What of the equipment makers, such as Lucent Technologies, Cisco and Nortel, that make broadband networks possible? They're too prone to up-and-down performance, Lawson says. As technological advances lead to changes in equipment, as well as market shares, companies can gain or lose ground with every new generation of products. This was illustrated by Lucent Technologies, once a Wall Street darling that has done a nose-dive, in part because its products have been eclipsed by better optical networking technology introduced by its competitors. "There's so much change, it's hard to know if you're going to be on top five years from now," Lawson says.
There is, of course, plenty of room for telecommunications to show improvement. The Dow Jones Telecommunications Index, for example, was down 31% in late February from a year ago. "It's a bad environment right now in the short run," Lawson says. "There is a shakeout you have to get through."
American business embraced technology in the 1990s. This decade, Royce Opportunity Fund's Buzz Zaino expects America's military to do the same-creating boom times for the aerospace and defense industries.
"You can do a lot more with smart weaponry than you can with iron or manpower," the small-cap fund manager says. "Military budgets will rise, especially for electronics and communications. It's just a matter of how much they will rise the next five years."
He stresses that this outlook is politically neutral. The Bush administration has called defense spending a priority, Zaino says, but he would have been high on aerospace and defense even if Al Gore had won the presidency. "I think the net effect would not be a lot different with either one," he says.
The reason: Technology has advanced so far that its absorption into the military establishment is inevitable. The cost-effectiveness of better technology will also factor into new spending, he says. Plus, technology is providing more opportunities to upgrade older systems, as well as build new ones.
Everything, from the proposed missile-defense system to communications systems to the equipment used by individual soldiers, will play a part in the growth, he predicts. That, he says, is good news for small-cap investors. "The nice part for small companies is they tend to supply material for whatever programs get funded," he says.
He cites as examples some of his fund's recent purchases. Cubic Corp., a maker of fare-collection machines for mass-transit systems, has been making inroads in cutting-edge training, communications and surveillance equipment for the military. Nearly 40% of the company's business is defense-related. The company also has expanded its market to other NATO countries, including Great Britain, with which it has a contract to provide attack helicopter simulators. "While there is other competition, they are one of the technology leaders and have consistently won their share of the business," Zaino says.
Comtech Telecommunications, another Royce Opportunity Fund holding, recently won a $400 million contract to provide mobile and satellite-based communications systems for the U.S. Army. Evans & Sutherland Computer Corp., also held by the fund, makes hardware and software used to produce 3-D images for training simulators. The company derives more than 50% of its revenues from defense contracts with the United States and Great Britain. Zaino also likes EDO Corp. which makes a variety of systems for all branches of the military, and DRS Technologies, which specializes in surveillance and radar systems.
Look no further than the American household for Richard Drake's view on the market's up-and-coming sectors. Here's what Drake sees: computers, printers, television sets, game consoles, DVD and videocassette players, stereo systems, telephone answering machines and an assortment of other consumer electronics gadgets-all tethered to an electrical socket.
And that's just in the home. Include things like land-based and cellular phone networks, the Internet and private data, and you're talking about a lot of machines that require a lot of juice.
Taken together with the energy crisis in California and the simple mechanics of supply and demand, it's no wonder Drake is placing his bets on independent power producers. "There is a drastic shortage in electricity and a huge increase in the demand for electricity," he says. "In addition to the population growth we have, our lifestyles have changed so much in the last 10 to 30 years, where we're using much more electricity."
Drake notes that the demand for electrical power is growing worldwide, so power companies that can tackle international sales will have an edge. That's why his fund owns AES Corp., one of the world's largest independent power producers. Drake likes the company's move into South America and the fact that its annual growth rate in recent years has averaged about 30%.
He's also keeping an eye on companies that build power generators and the fuel cells that are used as backup power supplies. Among the companies he's watching are MasTec, a telecommunications- and energy- infrastructure construction firm, and Quanta Services Inc., a contract services company for telephone, power and cable-television companies. Another potential beneficiary of expanded power demand this decade is Enron Corp., an electricity broker, which he feels will benefit from interregional electricity sales spawned by deregulation.
As for any other sectors that might light up the stock market this decade, Drake says he feels the Internet build-out has a lot of steam left. "I think the Internet is going to be huge in the way companies conduct their business in the future," he says. Drake is not talking about companies such as Amazon.com, but rather more established companies such as General Motors that are using the Internet to increase productivity. In this sector, he likes Cisco, a leading provider of Internet infrastructure hardware, and Oracle, the database software company. The two companies have been fund holdings for about two years, and Drake continues to buy them despite taking a major hit during the recent technology sell-off. "We're going through sort of a catch-up period. Everything got way ahead of itself," he says. "Eventually, things will take off again."
Fremont Institutional Advisors isn't hedging on its view that biotechnology will dominate the market this decade. The company is starting its first sector fund in the spring-focusing on health care and biotechnology.
"We don't think technology is going away, but we think there are powerful applications in biotechnology," says Nancy Tengler, company president and manager of the Fremont New Era Value Fund, which was started this year.
Gene Sit, president of Sit Mutual Funds, also expects biotechnology to be the prominent sector in the first decade of the 21st century. This isn't a case of one sector, technology, falling out of favor and being displaced by another, he says. Like Tengler, Sit sees this as a new step in an ongoing technological revolution.
"People talk about the human genome and DNA research, but you have to step back and ask, 'Why did this happen?'" Sit says. "It was part of the whole technological revolution in the entire decade of the 1990s ... Think of it as the health sector taking all the technological developments that happened in the '90s and applying them to their industry and using it to enhance their productivity in research."
If history alone was used as a guide, investors could have reason to be skittish about this sector. Biotechnology experienced several periods of intense speculation in the 1980s and early 1990s. Like technology in the late 1990s, the biotechnology craze died down, resulting in a collapse of prices.
Why is there reason to expect things to be different a second time around? Sit and Tengler say there are several compelling factors that point to a sustained period of growth for the sector. Biotech companies are more established today and now have real products and revenues. Another obvious factor is the aging of the baby boom generation, they say, and the increased demand this will create for health-care services and medicines. "Basically, in about 20 years, we're going to have as many people retired as we have working now," Sit says.
The generation's greater disposable income and what looks to be a more benign regulatory environment also should benefit health care, Tengler says. "Demographically speaking, I don't think it can be much better," she says. "The demand for pharmaceuticals is going to increase dramatically for preventative as well as therapeutic health care."
One of Sit's associates, Erik Anderson, vice president of investment management and research, adds that the United States is not the only country with a population bubble. "If you go into Europe and Japan and other economically developed countries, they're in the same state with aging demographics."
Another difference between now and the 1980s: the biotech sector has gone from being a group of fledgling companies with no real products to a more mature industry with strong drugs on the market and in the pipeline. Research and development budgets have grown, as have earnings and revenues, they say.
"These companies have been around now for more than a decade," Sit says. "The maturation is important." Tengler and Sit point to Amgen, which since 1986 has grown from a market capitalization of $100 million to more than $70 billion. It's now the largest biotechnology company in the nation and tops the list of stocks favored by both managers.
Most of Amgen's growth has been derived from its two primary drugs: Epogen, an anti-anemia drug, and Neupogen, an immune-system stimulator. Among the drugs in the company's pipeline are second-generation versions of both medications. Tengler and Sit also noted Amgen deftly collaborated with companies such as Johnson & Johnson and Hoffmann-La Roche to add bulk to its marketing and research muscle. "They've got pretty strong existing products and a pretty interesting pipeline in areas where there is not a lot of competition," Tengler says.
Sit is projecting the company's annual sales growth will rise from 15% to as much as 30% in the next five years, and its sales base will jump from $3 billion to $8 billion.
The mapping of the human genome, meanwhile, is already leading to early-stage drug development, Sit notes. Human Genome Sciences, for example, is conducting human trials on a heart disease drug that was developed through genetic research. "That is just one example of a drug that was purely derived through sequencing techniques," says Jon Loth, a vice president of investment management and research at Sit Mutual Funds. "I think what it points to is more robust drug development at the early stages."
Other companies owned by Sit's mutual funds include MedImmune, whose pipeline includes vaccines for urinary tract infections and a virus linked to cervical cancer; Genzyme, which has been expanding its niche products through acquisitions; and IDEC Pharmaceuticals, whose best-selling drug Rituxan, treats non-Hodgkin's lymphoma. Among small caps, Sit owns Biosite Diagnostic, which specializes in diagnostic products, and Cell Therapeutics, whose anti-leukemia drug Trisenox is being tested as a treatment for other cancers.
Tengler feels traditional large-cap pharmaceuticals also will excel by capitalizing on collaborations with smaller biotechnology companies. "The large caps have done an excellent job at joint venturing with biotechnology," she says. That trend should continue, she says, as large caps often can act as effective marketing arms for niche biotechnology companies. Tengler likes the drug pipelines of American Home Products and Bristol-Myers Squibb.
American Home Products has been hobbled by ongoing litigation involving the fen-phen diet drug. The company, however, entered into a $3.75 billion settlement last year. "The problem has been the uncertainty of the diet-drug litigation, but they got that settled pretty nicely," Tengler says. She adds, "They've got the best large-cap pharmaceutical pipeline around."
Brandywine Fund's Foster Friess is adamant in how best to pick this decade's hot sector: don't.
"We don't spend time worrying about near-term 'hot sectors,' let alone consulting a crystal ball to identify pockets of the market that will be 'hot' for the next decade," Friess says. "Individual companies are our focus."
Friess' philosophy may make for a good debate, but it's hard to argue with his results. The Brandywine Fund was among the few that defied the topsy-turvy nature of the market in 1999 and 2000 by beating the Wilshire 5000 by more than 15 percentage points in both years.
That's a noteworthy achievement, considering the complete turnaround of the riches-to-rags technology and Internet sectors during those two years. It was also a two-year period that saw growth investing rise to soaring heights and then tumble into negative territory by 20 points or more. Value investing, meanwhile, went from being chump to champ.
How did the Brandywine Funds maneuver around these powerful trends? Not playing the sector-picking game was one way, Friess says. "Most fund managers bet that the 'hot' sector of 1999, technology, would again lead the market in 2000, and they were burned for doing so," he says.
Brandywine stuck with its strategy of looking for companies with three years of earnings history and at least $3 million in after-tax income. The fund also looks for companies with at least 20% annualized earnings growth and P/E ratios of less than 20. That ruled out much of the technology sector and led to more holdings in the energy, health-care and utility sectors, he says. The result was a 7.1% gain in 2000.
Friess acknowledges that some trends, if read correctly, sometimes can point to favorable conditions for certain industry sectors. The aging of the baby boom generation, for example, is often cited as a potential boon to a variety of sectors. But Friess doesn't buy into the belief that demographic trends, by themselves, should be used as the basis for picking stocks.
Of the baby boom generation, he says: "Sure, you can say long-term-care insurance, assisted-living facilities and the like will be in greater demand, but so might sailboats, gardening tools and chewing gum. Who really knows?" he says.
Then again, the debate over picking a hot sector may just be semantics. Regardless of the reason, funds do tend to be more heavily weighted in some sectors than in others. Even the Brandywine Fund had more than 16% of its assets in each of the retail, energy and health-care sectors in 2000. Friess, however, contends that was not a planned strategy but a weighting that resulted from bottom-up research. "For example, our research on a cell-phone maker might lead us to its chip supplier, the company that created the liquid-crystal display technology for its phones and the contract manufacturer that assembles the phones," he says.
But Friess, in the end, does acknowledge there are times when industry trends are too powerful to ignore. "Rising oil and natural gas prices last year had us taking a close look at more energy companies than we might under different conditions, but in the end, we still made all our decisions in a company-specific manner," he says.
If anything, Friess says, the lessons of late 1990s should dissuade investors from wishing for a "hot" sector to buy into. "The technology/Internet surge of the late 1990s was characterized by a temporary disregard for fundamentals and valuations," he says. "I shudder to think investors would ignore the lessons of the dotcom debacle."