Tech Stocks for Value Hounds

The tech sector isn't the exclusive domain of growth managers--the S&P 500 sports a 20% stake, after all--but relative to their blend and value counterparts, it is a favorite growth fishing hole. Growth funds are the biggest shareholders of bellwethers such as  Apple (AAPL) and  Google (GOOG), and the bulk of holdings in  Technology Select Sector SPDR (XLK), an exchange-traded fund that carves out the S&P 500's tech and telecom components, lands in the growth column of the equity style box. The typical fund in Morningstar's growth peer groups has over a fourth of its assets (26.4%) in tech stocks.

Apple's recent evolution from R&D-focused cash-hoarder to modest dividend-payer, however, coincides with increased tech exposure among blend and, especially, value funds. Across Morningstar's value categories, the typical fund has allocated roughly 12% of assets to technology companies. That more than doubles the figure from five years ago (5.5%) and comes close to doubling the percentage from 10 years ago (6.1%). The increase has been especially pronounced among small- and large-value funds. For that subset, the five-and 10-year average tech exposures are 3.4% and 4.4%, respectively.

Case in Point
There are many forms of value investing, but for managers who pursue absolute value strategies, any stock can be a bargain, potentially. Provided the gap between the manager's estimate of a firm's intrinsic value and the market's measure of its worth is sufficiently wide, the company can be a portfolio candidate.  

That's the tack at Harris Associates, the parent firm behind the Oakmark fund family. The Chicago-based asset manager has a well-earned reputation for value investing, not least because its roster includes Bill Nygren and David Herro. Those two managers have racked up kudos and peer-besting returns with a strategy that permits them to buy bargains wherever they find them. They've also been instrumental in crafting the absolute value approach that Harris has used with remarkable success across the Oakmark lineup. (Four of the firm's seven funds have earned the Morningstar Analyst Rating of Gold, two have earned the Silver rating, and one has earned the Bronze rating.)

At the end of 2012's first quarter, most of Oakmark funds had something else in common: substantial technology exposure. On the domestic side of the shop's lineup, Nygren's concentrated  Oakmark Select (OAKLX) charge held the largest tech stake. With just over 30% of assets invested in the sector, the latest portfolio sports a double-digit overweighting relative to the category norm, the S&P 500 benchmark, and the fund's historical average. As with most of Oakmark's funds, Select's tech exposure has been ticking up in recent years. The fund didn't crest the 30% mark until September 2011, though, and during the past 10 years, it's averaged just less than 18% in the sector.

Elsewhere, Nygren's more expansive  Oakmark (OAKMX) has averaged 13.3% during the past decade; now its tech stake stands at more than 25% of assets, a smaller but still significant overweight position.  

Among the firm's international funds, more than 35% of assets at both  Oakmark Global Select (OAKWX) and  Oakmark Global (OAKGX) were invested in tech firms at the end of the first quarter. As with Nygren's domestic-equity funds, these exposures are also significant overweightings to both the benchmark (the MSCI World) and the fund's historical averages. Oakmark Global has averaged just over 20% in the sector during the past 10 years. And since its 2006 inception, the concentrated Oakmark Global Select--which Nygren and Herro comanage--has averaged 24%.  

Tech Tea Leaves
Oakmark's managers don't invest in the tech sector, per se. They invest in individual firms that meet their stringent fundamental and valuation criteria and let the sector allocations fall where they may. With that in mind, it's telling that Oakmark's purely bottom-up process has recently led to big tech stakes in most of its funds. Connecting the dots between the firm's overarching strategy and its tech exposure may help explain what other like-minded value hounds have been seeing in the tech sector.

First, in the aggregate, tech stocks strike an attractive valuation profile right now. Even after the sector's recent runup, the typical tech fund's average P/E reflects just a modest premium relative to the S&P, and its average price/book and price/sales multiples currently fall below the S&P's. That's the case despite the technology peer group's much better growth measures. The typical tech fund's average sales, cash flow, and book-value growth metrics all trump the S&P's by wide margins--over 45 percentage points in each case. There's a similarly large gap between the market's and the category's historical earnings. On the theory that stock prices eventually follow earnings growth, the appeal of the technology sector for value hounds isn't hard to see.

Second, the sector's fundamentals should look especially attractive to investors who, like Oakmark's managers, favor financially healthy firms that appear to be trading at steep discounts to their intrinsic value. In addition to its superior growth attributes, the typical tech fund's holdings are, on average, both financially healthier and more profitable than the broader market as gauged by the S&P. It has higher cash return and free cash flow yield figures, too--indications that the typical tech fund owns firms whose managers have put capital to work more efficiently and with above-average success.

It's true that, according to Morningstar's equity-research group, the percentage of firms with economic moats that reside in the typical tech fund's portfolio falls slightly below the S&P's moat percentage. Still, roughly 85% of that fund's assets are invested in firms that do possess sustainable competitive advantages (that is, economic moats).The figure for the S&P, whose companies enjoy wider moat coverage from Morningstar's equity analysts, clocks in at 91%.

Drift Away?
Attractive valuations and fundamental strength don't guarantee investment success in any particular market cycle. Indeed, during 2009's risk-fueled rally, solid profitability and robust financial strength worked against many companies and the mutual funds that held them. Moreover, most investors probably have all the technology they need, given that the sector accounts for roughly 20% of the S&P 500.

However, investors who may be scratching their heads over the level of tech exposure they're getting from their value and blend funds shouldn't assume their managers have drifted from their strategies to become free-spending buyers of richly priced growth stocks. These days, even deep-seated blue-light specialists should be able to find much that they like down the market's tech aisle.