Currently there is large open source software growth in Asia. IDC Enterprise Server Tracker is predicting that Linux based servers will grow 31 - 40% every year through 2007. E*Trade Japan is the first financial services company to use Linux Operating System (OS) to support their online securities trading system. (Open Source Gaining Traction in Asia) Also, the French government has announced a plan to move a significant number of the desktop PC’s to a Linux OS by 2007 (French Officials Eye Open-Source Apps). In May of 2003 the local government of Munich, Germany announced that they are going to convert all of their 14,000 Windows based desktops and notebooks to a Linux OS. Outsourcing programming jobs to countries with cheaper labor costs is a threat to the US economy, but this should allow companies within the industry increase their margins.
There is a very large potential for growth in the software industry considering that this is a global industry and a majority of the world’s population currently do not have access to PC’s. The first area for growth is within the Internet services sub-industry. Here there is the potential that we will move from smart terminals back to dumb terminals, where all of our applications and data will be saved on an off-site server. This would create a large demand for a different style of software that would be needed to support this change. The second area for growth is with the wireless technologies. As the technology becomes available to transmit data at high speeds across wireless networks, we will need new software that will support this new application of transferring information. The third growth prospect is that we are beginning to see a move from proprietary software to open source software, particularly with operating systems. The growth of open source software has the potential to increase the quality of software across the board, and decrease market prices.
The industry as a whole is seeing signs of maturity, since there are many consolidations that are taking place. The maturity of this industry is still about a decade off, thus there are a lot of profits to gain from the future positive net present value (NPV) projects. Industry supply has greatly increased over the last 5 years, which has been the major factor of the falling prices.
Software is divided into system software (e.g. Microsoft Windows), and application software (e.g. Microsoft Word). The Internet sub-industry is made up of online databases, interactive services, and Internet design services. Both of these sub-industries target businesses and consumers alike.
Concentration is within the software sub-industry with Microsoft dominating the industry. They have also engaged themselves in the Internet Services sub-industry as well with their MSN network.
The Software and Internet sub-industries are easy to enter, since they are not a largely capital intensive area, compared with hardware manufacturing. A virtually infinite amount of opportunities with positive returns exist within this industry. It will take many years for all of the firms in the industry to deplete all of the opportunities that exist.
There are by far more customers than there are suppliers, thus the supplier has control over the market. The power of just one firm, Microsoft, which has a 90% of the OS market share. In the near future, 3-5 years, we will begin to see a change in this power of the suppliers, as competition increases.
Currently we are seeing very high competition as the industry is trying to outdo one another. The prices on many software products have been decreasing slightly, but not nearly as fast as the hardware and semiconductor industries. The competition for OS software is not real great as of yet, but there are many signs of it heating up (French Officials Eye Open-Source Apps).
Within the Software and Services industry the potential exists for substitution in the near future, with the expansion of open source programming. Linux is an open source option that will someday change the industry with their free OS. As the consumer market becomes more open to other program options they will find that the Linux OS is a cheap alternative to the Windows OS. Also available for free download is OpenOffice, which is an office suite similar to Microsoft Office. This free software bundle is almost as powerful as Microsoft Office, but it is improving rapidly.
TECHNOLOGY AND HARDWARE EQUIPMENT
This sector maintains a broad range of interest from both businesses and households. Providing instruments such as personal computers, wireless phones, mainframes, and other various computer equipment, the need for these products has become an integral part of many societies. This creates a constant demand for such products.
The Technology and Hardware Equipment industry is a broad industry composed of sub-industries such as Communications, and Computers and Peripherals. Communications is a rapidly growing sub-industry because of heightened demand for high quality communications, whether it is through high-speed Internet connections or wireless phones. Telecommunications hardware especially is growing rapidly. As the demand for cellular phones grows both here and abroad, this industry will see continued expansion.
Computers and Peripherals is a sub-industry that is in the maturity stage of its life cycle. While there is always room for growth and improvement in the industry, any radical growth in this sub-industry would probably be an inception of a new sub-industry rather than an expansion of the current.
With the industry being mature, several manufacturers need to look to expand market share in order to increase revenues. This heightens the level of competition between firms. In such a global market, there are several smaller foreign firms that could attempt to gain more market share by producing at a lower cost. This is true for producers such as Legends, Inc. China which is rapidly gaining market share within China.
SEMICONDUCTORS AND SEMICONDUCTOR EQUIPMENT
Semiconductors and Semiconductors Equipment relies heavily on the sale of computer chips and some memory devices. While it may seem like a homogenous industry, there are several different technologies that fall into this category making it more diverse than it seems. In some ways this is the sub-industry that has the most potential for growth, placing it squarely in the growth stage of the industry life cycle. This industry shows some characteristics of cyclical industries, barring vast departures from the norm. For instance the late 90s showed greater than average results.
This is an industry fueled by the need for technology. Demand for faster computers, easier communication, and portable devices create a steady demand in the industry. With demand so constant, other external factors are likely to have more of an influence on the industry.
Recently, there has been much reported about U.S. based companies relocating to other parts of the world, namely India and China. China in particular is aggressively encouraging these moves, hoping to become a worldwide leader in this industry. India too, welcomes the new business, hoping to create a new industry home. While much has been publicized that criticizes these moves from a labor standpoint, looking at them with an investment focus shows great promise. Less costly labor can increase demand (because of lower prices) and widen profit margin. This is important to remember when analyzing these industries. Because the customer base is so well spread, profits will increase, mainly by producing new products more efficiently, not by gaining more customers. Every business has some type of tie to the information technology sector, as do most households in developed and developing countries. Therefore, by transplanting themselves in the Far East, chipmakers give new hope to the industry.
To reiterate, this is an industry that consists of one industry leader, Intel, and several followers. Therefore, it is possible to compete with several of the lower tiered firms, but much more difficult to compete with the industry leader. The major barrier to entry is the capital-intensive nature of the industry. Even though some chipmakers offer rather similar products to Intel, these products have not gained the market share that Intel has. So in this sense, it is not difficult to enter this industry, but very challenging to gain prominence.
FINANCIAL ANALYSIS
As the following numbers show, there was a dramatic rise in sales and sales figures in the late 90s. However, as the economy fell into recession, information technology stocks also drastically fell. However, it is important to realize that the “bubble burst” was simply a correction in prices, not a downturn in the sector. Of course, during the recession several firms and households put off improving IT, but with recovery underway, sales figures were improved in 2003 (not yet available) and expected to rise again in 2004.
(Research Insight)
A review of margin and turnover ratios yields similar conclusions. Again the late 1990’s steadily grew, with margin and return on equity peaking in 1999. However, after that, the sector began to decline rapidly. Again, while the numbers for 2003 have yet to be released, all industry reports show a reverse of the declining trend. The upward trend is expected to continue in the near future. Some signs of recovery were seen in 2002 when margin rose 11 percent, but still failed to be positive.
(Research Insight)
As fore mentioned, growing sales and margins are expected to continue. The following valuation analysis shows that this sector has some favorable opportunities. Some investors have lingering fear from the bubble burst, which makes it possible to find undervalued stocks. Certainly, the sector has industries that will continue to grow.
Major Companies Within The IT Sector
Software
- Microsoft Corporation (MSFT)
- Oracle Corporation (ORCL)
- SAP AG (ADR) (SAP)
Semiconductors
- Intel Corporation (INTC)
- Texas Instruments Inc. (TXN)
- Taiwan Semiconductor Mfg. (TSM)
Hardware Equipment
- Cisco Systems, Inc. (CSCO)
- Nokia Corporation (ADR) (NOK)
- Dell Corp. (DELL)
(Yahoo Finance)
VALUATION ANALYSIS
The Information Technology sector as a whole is trading at a higher price than the rest of the market. This is mainly due to the fact that the sector offers much higher returns on its positive NPV projects. The sector is also quite volatile, but still growing at a much faster pace than most of the market. For the most part valuation is rather consistent across the sector with most firms trading near a Price-to-Earnings multiple of 40. Over the past few years valuation has been declining due to the fact that much of the sector was overvalued at the turn of the century. Now the sector has leveled off considerably to realistic valuation figures. The IT sector is expected to expand 34% in 2004 (Yardeni). We are expecting expansion of valuation within the sector over the next few years, because this sector offers so many growth opportunities that have yet to be exercised.
(Morning Star)
RECOMMENDATION
Upon reviewing past trends, current news, and a considerable amount of information regarding the prospects for the sector, we recommend that the fund overweight the Information Technology sector. The sector is satiated with opportunities for increased earnings. The dependence that the world has on this sector only strengthens our position. In fact, after reviewing the other sector analyses, it seems that some of this sector’s sub-industries have more opportunities than several other sectors. Simply put, the information technology sector has become an integral part of society. It can only improve and continue to spread to developing countries, but never go away.
This recommendation may scare some investors, since the “bubble burst” in recent years was largely influenced by the information technology sector. However, in our opinion, this fear is largely unfounded, based primarily on public perceptions with little regard for the facts of the situation.
We are fairly confident in this recommendation. Several industry experts see promise in the Internet sub-industry, as communications and technologies improve. In fact, Value Line ranked it second in a list of timeliness by industry. The semiconductor industry is also ranked favorably, as Standard and Poor’s just last week rated it as a “Buy”.
There are some schools of thought that suggest contrary opinions. Some scholars concluded after examining past bubbles, that the stock market bubble of the late 90’s has yet to fully burst. Their primary argument is that the market did not fall far enough before recovering. Other similar opinions are likewise abstract, and give little regard to the current happenings in the market and in the world.
Currently the fund’s investment in the information technology sector is high by comparison to other sectors. However, this is a diverse sector, with several opportunities. Furthermore, other sector analyses have suggested that money be shifted from their sector because of little or no growth. While we maintain that a diverse portfolio is important, we strongly feel that the information technology sector offers a vast array of opportunities and has the potential to give superior returns to other sectors. We feel that it is in the best interest of the fund to take advantage of some of the most enticing opportunities within the information technology sector rather than simply spread the money across the other sectors with little reason to do so. We can increase our holdings in this sector while maintaining a well-balanced portfolio.
We recommend that the Software and Services industry should be weighted similar to that of the Semiconductor industry, but greater than the hardware industry. This recommendation follows that the industry has many positive net present value (NPV) projects: Internet Services, Wireless networks, and Open source software. As the industry undertakes these projects the individual companies will reap the benefits of abnormal returns. The industry is projected to generate above average returns for the next 3-5 years. At least 25% of the firms in this industry are ranked with a “1” for timeliness by Value Line. (Value Line)
REFERENCES
Value Line: www.Valuelin.com
Yahoo Finance: finance.yahoo.com
Ed Yardeni: http://www.cm1.prusec.com/yardweb.nsf/(YardeniHome)?OpenAgent
Morning Star: www.morningstar.com
Research Insight
French Officials Eye Open-Source Apps: http://story.news.yahoo.com/news?tmpl=story&u=/pcworld/20040216/tc_pcworld/114759
Microsoft Responds to Real Networks Suit:
http://www.eweek.com/article2/0,4149,1417871,00.asp?kc=EWNKT0209KTX1K0100440
Open Source Gaining Traction in Asia: http://story.news.yahoo.com/news?tmpl=story&u=/nf/20040203/bs_nf/23116
The Wall Street Journal: www.wsj.com