Old tech is new darling of equity

income investors
Technology stocks have never been the best friend of the equity income
investor. Until the financial crisis struck in 2008, the yield on the MSCI
Global Technology index remained resolutely below 1 per cent, with many
tech companies simply not having the free cash flows to pay meaningful
dividends. Those that did generally preferred to splurge on acquisitions as
they chased market share in a frenetic land grab.

2014

Technology stocks have never been the best friend of the equity income investor. Until the
financial crisis struck in 2008, the yield on the MSCI Global Technology index remained
resolutely below 1 per cent, with many tech companies simply not having the free cash flows to
pay meaningful dividends. Those that did generally preferred to splurge on acquisitions as they
chased market share in a frenetic land grab.

And even after the global stock market sell-off briefly pushed yields above 2 per cent in late
2008 and early 2009, they sank back to little over 1 per cent in 2010.

However, yields have since climbed back above 1.5 per cent and some equity income fund
managers, at least, are starting to take note.

Traditionally, technology companies never really paid dividends, so we were unable to make
investments, resulting in us being structurally underweight technology for a long time, says
Nick Clay, co-manager of the 4bn Newton Global Higher Income fund.

However, of late some of the more mature technology companies have started paying
dividends and are increasingly doing so. You have the likes of Apple, Cisco and Microsoft, which
are all paying cash back to investors.

Jill Cuniff, president of Seattle-based Edge Asset Management, which manages $7bn in equity
income funds, adds: Back during the tech boom a lot of people thought these companies could
not grow and [simultaneously] pay a dividend.

We dont think that is true. A lot of them are sitting on a lot of cash. M&A [merger and
acquisition] activity has slowed down, therefore a lot of that [cash] is flowing back to
shareholders in terms of dividends and buybacks. We dont believe this is temporary.

Mr Clays Newton fund now has a higher allocation to technology stocks than at any point since
its launch in 2005, with its 8.1 per cent weighting only a little below its benchmark of 9.5 per
cent.

Others have gone further still and built double-digit exposures.

The 300m Baillie Gifford Global Income fund has a 15.3 per cent exposure to technology, the
92m Schroder Global Equity Income vehicle 13.2 per cent (second only to financials) and the
Legg Mason Global Equity Income fund 11.3 per cent.

Ian Kelly, co-manager of the Schroder fund and part of a value-investing team that manages
$13bn, believes the post-crisis hunt for yield has encouraged more mature technology
companies to change tack.

Previously [paying a dividend] was seen by investors, in the States in particular, as a sign that
there were no growth opportunities in the business. Things changed after 2008 and paying
dividends, and especially growing them, was seen as a strength and a sign of confidence in the
cash flow prospects for the business, he says.

Income managers are not buying tech stocks across the board, however. Potentially faster-
growing niches such as social media stocks remain off limits. So-called old or mature tech
outfits, such as Microsoft, Intel and Cisco are the ones in demand.

We are significantly overweight the sector vis--vis our peers, but it is skewed more to the
older tech companies, where valuation on a relative and absolute basis is very attractive, the
balance sheets are very healthy, there is very healthy cash flow generation and therefore they
have the capacity to pay out and grow a consistent dividend, says Safa Muhtaseb, co-manager
of the Legg Mason fund.

Income managers argue these stocks have fallen out of favour with traditional technology
investors because their growth rates have fallen, but they are adamant that does not mean
they have become post-growth pseudo-utility companies.

Our companies have real earnings, real cash flows. Their returns on capital employed are quite
attractive. Their industries may very well be maturing, therefore the revenue growth rate has
declined and they are growing at mid to low single-digit rates, but the earnings growth is there
as they become more efficient, says Mr Muhtaseb.

He lauds the likes of Corning, which makes glass for iPhones and tablets and is developing
antimicrobial glass, Wincor Nixdorf, a German manufacturer of cash registers and ATMs, and
TravelSky Technology, a Hong Kong-listed IT provider to Chinas travel and tourism industry.

Mr Kelly argues old-tech companies are superior to utility stocks as they tend to have lots of
cash on their balance sheets, often equivalent to 25-30 per cent of their market capitalisation.
This makes them safer than the many utilities that have loaded up with debt.

Mr Muhtaseb also sees these often-hefty cash balances Apple had almost $159bn in cash at
the end of 2013, and Microsoft $84bn as attractive, particularly if this money is handed to
shareholders.

Their balance sheets are suboptimal, they are inefficient. It is accretive to them to return cash
to shareholders. That is why we are seeing activists take positions in companies with hordes of
cash and agitating for significant [share] buybacks, he says.

And while he is acutely aware of the vicious technological obsolescence that can undermine
mature technologies, Mr Muhtaseb is confident that the companies he favours have sufficient
free cash flow to invest heavily in research and development and still pay chunky dividends.

Moreover, new opportunities are constantly emerging for the alert income investor. Mr Kelly, for
instance, says sequestration-driven US public spending cuts led many to conclude that military-
focused tech companies had gone ex-growth.

The resultant sell-off led him to scoop up companies supplying telecommunications to the
Pentagon and services to Nasa, the US space agency.

Mr Clay, for one, believes the trend for income managers to fish among the sea of technology
stocks still has much further to run.

We are underweight [the sector] because the trend of tech companies paying dividends is just
beginning. We have still got a long way to go, he says.

Tech Reviews by The Corliss Group