The next surge for tech stocks

Economically sensitive sector will benefit from the recovery, Mawer's Grayson Witcher says.

Sonita Horvitch 24 March, 2010 | 6:00PM

Grayson Witcher, portfolio manager at Mawer Investment Management Ltd., says that despite the surge in brand-name U.S. technology stocks, there is still scope for them to go higher as the U.S. and global economy continue to improve.

In 2009 the technology sector, up 62%, handily outperformed the benchmark S&P 500 Index, which was up 27%. So far in 2010, the tech sector has lagged the market benchmark.

Witcher says the technology sector is undoubtedly economically sensitive, and "you are starting to see a turnaround in the U.S. economy and renewed vigour in the global economy."

U.S. tech companies, he says, are reporting increased orders. For example, in its recent conference call, Cisco Systems Inc. CSCO said spending by its enterprise customers was on the rise and this should persist.

Calgary-based Mawer had assets under management of $6.7 billion at the end of last year. Witcher, who has a Harvard University engineering degree, joined the firm in 2006, with five years of experience in both the U.S. and Canadian investment business.

Appointed co-manager ofMawer U.S. Equity and the firm's U.S. segregated funds in the spring of last year, he assumed the lead manager role when veteran Mawer manager Darrell Anderson retired at the end of the year. Witcher is directly responsible for $480 million.

Mawer's model U.S. portfolio has 34 names with a median market capitalization of US$19 billion. "There is a good balance between defensive and cyclical stocks, with a slight tilt to economically sensitive sectors in the past two years."

Technology at 18% is the biggest absolute sector weight in the portfolio, though it is underweight relative to the S&P 500 Index at 20%. Next is health care at 16% (overweight relative to the index's 13%). Financial services represent 15% of the portfolio (14% in the index) and industrial stocks 14% versus 10%. "Industrials are our biggest overweight," says Witcher.

U.S Sector returns
S&P 500 sector index 2009 2010 YTD*
Consumer discretionary 41.3% 10.2%
Consumer staples 14.9% 5.6%
Energy 13.8% 0.1%
Financials 17.2% 9.9%
Health care 19.7% 4.5%
Industrials 20.9% 11.8%
Information technology 61.7% 1.4%
Materials 48.6% 2.4%
Telecom services 8.9% -3.5%
Utilities 11.9% -3.3%
S&P 500 (all sectors) 26.5% 5.0%
All returns are US$ total returns
*As of March 20, 2010
Source: Morningstar

The top three holdings are Cisco with a market capitalization of US$150 billion, International Business Machines Corp. IBM, whose market cap is US$167 billion and Microsoft Corp. MSFT, with a market cap of US$260 billion. They collectively represent 11.2% of the portfolio.

A bottom-up stock picker, Witcher says these three technology companies ably illustrate Mawer's investment discipline. "They each have dominant market shares and generate high returns on total capital invested (equity plus debt), which is "strong evidence of wealth creation for shareholders." Also, the stocks are reasonably valued.

As the leading global supplier of networking equipment for switching and routing, Cisco is benefitting from "the rapid growth in Internet traffic," says Witcher. It is also expanding its presence in the fast-growing video teleconferencing business. The United States and Canada account for 53% of revenue.

The rest is international, reflecting a strong presence in both Europe and the Asia-Pacific region. Cisco has produced an average return on capital of 22% over the last 15 years. The stock has risen sharply over the past 12 months, "but still trades at a discount to my estimated intrinsic value per share." On a P/E (price-earnings) multiple basis, the stock trades at 17 times estimates for the fiscal year to July 2010.

Witcher says IBM, which has been in the portfolio for some 10 years, "illustrates our buy and hold philosophy." The company "is at the intersection of technology and business in that it is concentrating on computer software and consulting." Its return on capital has averaged 16% over the past fifteen years. The stock, he says, is "quite cheap." It trades at a P/E multiple of 12 times EPS (earnings per share) estimates for 2010.

 
Grayson Witcher

Dominant in its field, Microsoft has successfully introduced its new operating system, Windows 7, says Witcher. In its other businesses, Microsoft is advancing its search engine Bing in competition with the market leader Google Inc. GOOG.

Microsoft has "done an outstanding job of generating wealth for shareholders," Witcher says, with a return on capital that has averaged 29% over the past 15 years. The stock trades at 15 times EPS estimates for the fiscal year to June 2010, "which is reasonable."

A smaller-cap diversified industrial company that "falls under the radar screen," says Witcher, is Illinois Tool Works Inc. ITW, with a market capitalization of US$23 billion. The company "has a good track record of making acquisitions to enhance its already prominent share in each of the markets it serves."

Illinois Tools offers a wide range of products including packaging, power systems and construction materials. "Each division is autonomous, as management is highly decentralized."

The company's average return on capital was 15% over the past 10 years. The stock trades at 17 times EPS estimates for 2010, "which is attractive." Witcher says there is some cyclicality to its earnings, so they should improve over the next two to three years.

In the U.S. financial services sector, a prominent niche player is State Street Corp. STT, with a market capitalization of US$22 billion. It is a leading provider of mutual-fund custody and accounting services globally, with US$18.8 trillion in assets under administration. It is second in the world in money management with US$1.9 trillion in assets.

"Its two businesses generate recurring revenue and there is a high client retention rate," Witcher says. The company has produced an average return on equity of 16% over the past 15 years. The stock trades at a "deep discount to my estimated intrinsic value per share" and at a "modest" P/E multiple of 14 times 2010 estimates. "Investors are concerned that stock and bond returns will be muted over the next few years, but my call is that they are being too conservative."

A "plain vanilla" retail and commercial bank, Commerce Bancshares Inc. CBSH, with a market cap of US$3.4 billion, "has seen a rapid rise in its stock over the last 12 months," and Witcher has reduced his holding. The valuation is "fair, but not overly attractive." This "high quality" regional bank stands out, he says, as it "avoided the high-profile issues that plagued the big money-centre banks."

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Sonita Horvitch

Sonita Horvitch