Smart Plays in the Tech Sector

American Funds' two growth funds,  AMCAP (AMCPX) and  Growth Fund of America (AGTHX), have had a roaring year so far in 2009, owing partly to their heavy technology weightings. On the surface, it hardly seems unusual that growth funds would have technology exposure, but these funds' timing, stemming, we think, from their valuation discipline, has been particularly good.

Recently, we compared how much technology exposure American's two growth funds have now to what they had in their March 31, 2000, portfolios. We found that the funds' technology exposure reflects American portfolio counselors' contrarian style and caution regarding valuation. Basically, the funds have more technology stocks among their top holdings than they did in the late 1990s, and that's been a boon to shareholders both in the market meltdown from 2000 through 2002 and in the early part of 2009.

How AMCAP and Growth Fund Were Positioned for the Tech Meltdown
In the early 2000s' bear market, which ran from March 1, 2000, through Oct. 31, 2002, AMCAP lost 18%, while GFA lost 35%. While these are painful losses, the S&P 500 Index lost 33%, the Russell 1000 Growth Index declined 55%, and the typical large-growth fund was down 51% during that period. American's growth funds held up quite well in relative terms during the technology meltdown, because the funds didn't gorge on technology stocks when they were richly priced.

A glance at AMCAP's portfolio from March 31, 2000, shows only one of its top-five holdings was a technology name-- Cisco (CSCO) in the fourth slot. The fund's other top holdings were medical device firm  Medtronic (MDT), media giants  Time Warner ,  CBS Corp (CBS), and  Liberty Media (L), and staffing firm  Robert Half International (RHI). Technology-, telecommunications-, or Internet-related stocks comprised 11 of the top-25 holdings, and only one holding, Circle.com, doesn't exist anymore. All told, the fund's exposure to hardware, software, and telecommunications was 27.6%. The S&P 500 Index's weightings in these sectors was 36%, by contrast.

Besides Cisco, the fund held large, non-dot-com names  Texas Instruments (TXN),  Microsoft (MSFT), and  Oracle (ORCL), but it also held non-technology stocks, such as  Wells Fargo (WFC), staffing firm Concord EFS, and retailer  Kohl's (KSS). Those stocks posted big gains during the bear market, helping offset losses in other areas.

It's also worth noting that AMCAP entered the technology bust with 16% of its assets in cash, which appears to have been a brilliant move in retrospect. AMCAP is one of American's most flexible funds, and it used its ability to hold cash well during the technology meltdown.

Growth Fund doesn't have quite the flexibility that AMCAP does, and it tends to hold a bit less cash. Still, it entered the meltdown with around 13% of its portfolio in cash. It did hold more technology stocks than AMCAP--13 instead of 11--among its top-25 on March 31, 2000, however. On the whole, its holdings were smaller, racier stocks, including small semiconductor firms  PMC Sierra ,  Micron Technology (MU), and  Vitesse Semiconductor . The fund also held media firms Time Warner, CBS, and News Corp., along with health-care firms HCA,  Cardinal Health (CAH), and  Wyeth .

Interestingly, though, Growth Fund was unloading technology stocks prior to its March 31, 2000, portfolio. Among the positions seeing the most shares sold were  CA  , Microsoft,  Maxim Integrated , WorldCom, and  Intel (INTC). Growth fund held a whopping 51% of its portfolio in hardware, software, and telecommunications, but it had also started to sell chunks of its technology stake before the end of March.

By the next portfolio (June 30, 2000), there were 11 technology stocks in the top-25, and the fund had added significantly to  Starbucks (SBUX) and also to Pharmacia, which was eventually purchased by  Pfizer (PFE). By Sept. 30, 2000, the fund's top-25 holdings contained only six technology stocks, as the fund added insurers  Berkshire Hathaway (BRK.A) and  Marsh & McLennan (MMC) from scratch to its top-10 holdings, and added to other non-tech stocks. The Sept. 30, 2000, portfolio also reveals large sales in Micron Technology, Vitesse Semiconductor, PMC-Sierra, Applied Materials,  Jabil Circuit (JBL), Cisco, and  Juniper Networks (JNPR).

Growth Fund's racier fare caused it to drop slightly more than the broad market during the tech meltdown, but it made some nifty  moves and wound up doing well against its growth brethren, if not the S&P 500 Index.

Tech-Heavy in '09
The technology meltdown may be a distant memory, but tech stocks have never really regained their late-1990s mojo. Fittingly, the contrarian counselors of both AMCAP and Growth Fund came into 2009 loaded to the gills with technology, telecommunications, and Internet-related businesses. Among AMCAP's top holdings on March 31, 2009, were Microsoft,  Yahoo , Oracle,  Google (GOOG), Cisco,  Corning (GLW), SAP, and  Apple (AAPL). Each of those stocks is up well over 10% for the year to date through June 30. AMCAP's telecommunications weighting is four times larger than that of its average large-growth peer, according to Morningstar's statistics.

Growth Fund similarly counts Google, Oracle, Cisco, Apple, and Microsoft among its top-five holdings. Yahoo and  EMC   come in as the ninth and tenth largest holdings. The fund's telecommunications exposure is five times the exposure of the average large growth fund.

So what are the counselors finding compelling about the tech sector? We can't be certain, but based on recent stock prices relative to the companies' modest growth expectations, maybe valuations look low. Tech stocks are much cheaper now than they were in the late 1990s and the early part of this decade by nearly any measure. For example, in 2000, Cisco's P/E ratio was 94. In 2004 it was 26, and now it's around 15. Corning sported a P/E ratio of 114 in 2000 and now trades with a P/E of less than 10. Even Google, which sports a P/E in the mid-30s, traded at a price more than 100 times its earnings earlier this decade. It's no surprise, therefore, that American's counselors have taken a shine to these stocks, given how cheap they're trading on a historical basis.

Showing Some Speed
Just how compelling are these tech stocks? AMCAP picked up more than 18 million shares of Corning in 2008's fourth quarter, making it the 27th largest holding. That's quite a move for a group of counselors known for moving slowly and incrementally. During that quarter, the stock had dipped to around $7.50 per share. The stock now trades at around $17, more than double its price from late November 2008, when it appears American was buying. That surge helped push the stock to the fund's 10th largest holding by March 31, 2009, and filings show that American had trimmed 1 million shares during 2009's first quarter. American reveals its funds' top-10 holdings monthly on its Web site, and as of May 31, Corning is no longer in AMCAP's top-10, indicating that the counselors probably sold more.

We looked for a Corning-like situation at Growth Fund--where the counselors piled into a compelling stock--and we didn't see one. It's possible that Growth Fund's $131 billion in assets prohibits it from making such dramatic moves as AMCAP did with Corning. Growth Fund owned 71 million shares of Corning as of March 31, 2009. That's good enough to make it the 20th largest holding, but it's also about 4.6% of Corning's total outstanding share and more than three times the amount of shares it took to make Corning a top-30 position in AMCAP.

Although it did it with Berkshire Hathaway and Marsh & McLennan in 2000, it may be getting difficult to boost a stock to one of GFA's top holdings within a quarter. Still, the fund's performance doesn't indicate an asset bloat problem. Growth Fund actually has outperformed AMCAP over the past decade as well, with a 2.5% annual return versus a 1.3% annual return for AMCAP, and AMCAP and Growth Fund are both up over 12% for 2009 through July 28, 2009. AMCAP, however, has delivered a more stable ride. Its longest downstreak over the past decade has been a five-month stretch where it lost 14%, while Growth Fund had a six-month downstreak when it lost 48%.

Getting Back More 
This contrarian approach to growth investing has served American's growth funds well. Technology stocks aren't growing the way they used to, but they probably still afford decent prospects for growth. Investing is "laying out money today in order to get back more tomorrow," as Warren Buffett incessantly reminds us, which means that stocks are cheap or dear depending on future earnings or profits, not on past P/E ratios. This makes investing in growth stocks especially tricky, since optimism about future earnings is typically built into prices. Are you laying out a reasonable amount of money today for technology's future earnings? Will the future earnings that current prices anticipate materialize? American's counselors clearly think they will for yesterday's forgotten tech darlings. So far, that bet has paid off in 2009.

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