Tech's Potential Underappreciated

Greg Carlson: Hi, this is Greg Carlson. I'm a mutual fund analyst with Morningstar. I'm joined today by Andy Stephens, the manager of Artisan Mid Cap Fund and Artisan Opportunistic Growth. He's also a co manager on Artisan Small Cap Fund. Andy, thanks for joining me today.

Andrew Stephens: Thanks for having me here, Greg.

Carlson: Andy, one of the notable things about this fund, which resides in Morningstar's mid-cap growth category, is that is has a pretty sizable allocation to tech stocks these days, which is fairly unusual compared to its history. Can you talk a little bit about the rationale for that in the areas that you're interested in within the sector?

Stephens: I guess we've never really thought about it from the top down and said we want to be this much in technology. It's just a couple of things, I think. One, we've found a number of very interesting trends in the world that we think are best manifested in some of these companies. Two, I think that tech has become almost a bad word, and it's a very distrusted area of the market. So I think relative to the benchmarks and to a lot of our peers, what we think is a very manageable sized weighting has begun to look quite large.

But the trends that we're looking at and what we think you need going forward are real secular drivers or things that can propel the profit cycles of these businesses beyond just a recovery in the economy. We think those are best found in innovative companies. When you add all that up, I guess we end up with a little bit of a bigger weighting in technology.

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Carlson: Can you talk a little bit about the case in terms of valuations for tech? Obviously it's had a pretty poor decade in terms of performance. But we were, as we talked about earlier, working off some of the excesses of the bubble in '99 and 2000, and also it has performed quite well over the past year just bouncing off the bear market bottom.

Stephens: Yes, it has performed quite well off the bottom, along with, honestly, most areas of the economy. I used this story earlier, but in 2000 technology was 51% of the Russell Midcap Growth. Everybody had to own it, and it had quite lofty valuation. Today it's about 14-15%, and we think it's quite reasonable on valuation. It's really been 10 years of working off that excess, but when you look at it just holistically we've seen work that says today the technology sector as a whole trades at about a 6.5% free cash flow yield, which is 300 basis points better than the 10-year Treasury, yet it's growing. It's free cash flow, growing earnings.

We think that maybe institutionally people have forgotten about technology, and yet we see some pretty compelling reasons to own it, if nothing other than businesses have become more and more dependent on their technology and they will continue to spend to keep up their technology. We think there's a big capital spending cycle coming, so it's quite inexpensive in our way of looking at things.

Carlson: So you're focusing in particular on some of the business-oriented ends of the sector, such as data storage, as we talked about.

Stephens: We are. We think there are some very big trends in technology that are compelling. Some of them have been in place for a while and are continuing to grow as the penetration goes up, things like server virtualization, which is now bleeding over into storage virtualization. As soon as you virtualize your servers, eventually you're going to have to virtualize your storage, and ultimately you'll virtually your desktop computers. That's a big trend where we see the combination of hardware and software making the IT role more seamless.

But there are other things in the consumer world that are also driving growth, and the biggest one we see is this move towards smart, mobile, connected devices--things like smartphones, and tablets, and iPads, and things of that nature where people are turning in their old cell phone to get more intelligence at their fingertips. That's a big trend that's just started, and it's global.