Three tech-sector gems

Each week, a professional investor tells MoneyWeek where he’d put his money now. This week: Bolko Hohaus, fund manager, Lombard Odier Technology Fund.

The technology sector has a lot going for it: growing markets and plenty of press coverage. Apple’s new iPhone launch shows how much interest the sector can attract.

But despite all this attention, many large technology companies are all too happy to reach for the financial engineering lever and engage in huge share buybacks. In other words, they buy their own shares back from investors.

The tech giants like share buybacks because buying back shares can help to keep a share price high and boosts earnings per share (EPS). For example, Apple spent $18bn on its own shares between January and March 2014 and has seen its share price rally 23% this year.

Yet, these buybacks often soak up huge numbers of share options that have been given to managers and staff. If that’s the case, then firms are really engaging in ‘fake share buybacks’ that are barely reducing the number of shares in issue.

Microsoft is a good example of this. In the year to June 2014, it bought back shares worth $6.7bn, equivalent to more than 2% of its market value. But the share count only fell 1% because options were being issued to staff.

That means 1% of the firm, or $3.2bn, was given to employees, equal (if the same amount had been paid out in salaries) to 10% of Microsoft’s operating costs. A 10% increase in costs would hit all sorts of things, such as Microsoft’s perceived growth rate, its margins and directors’ salaries.

Over the last five years, it’s spent $29.3bn on buying back shares, but of that, $18.8bn merely served to soak up newly issued shares, mostly caused by share options.

The effect on profit growth is dramatic. Let’s say you add back the cost of buying newly issued shares to the salary bill over a five-year period. If you did that to Microsoft’s accounts, its underlying EPS growth would have been 5% a year, rather than the reported 9% figure.

For IBM, it would be 8% rather than 14%. The standard accounting rules mean the cash cost of soaking up share option awards via share buybacks isn’t fully reflected in company accounts.

Firms that waste their cash flow on these fake buybacks could instead pay larger dividends to shareholders; or management could use the cash to invest in acquisitions or research and development.

A lot of these firms have business models that are vulnerable to new players, and they need to invest to keep up with the latest trends, such as the ‘cloud’ or the ‘internet of things’. (The ‘cloud’ refers to using software that is provided over the web, while the ‘internet of things’ is about everyday items being connected to the internet.)

That said, there remain plenty of jewels in the tech industry, and these include some big companies. We like Google’s ‘internet of things’ pipeline and sound mobile strategy.

With a reasonable valuation and positive growth outlook, we think Google (US: GOOG) has good long-term prospects. Splunk (US: SPLK), a great innovator in machine-to-machine communication, is another company with exceptionally strong growth and a vast potential market to tap in to.

We also like Visa (US: V). Its capable management team has a strong view on how the company’s market will develop, and has implemented its strategy effectively. What’s more, Visa is a dominant player in its market. Investors also appreciate its cash return policy.

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