Technology: is it finally time to buy more chips?

Technology stocks are coming back into fashion. The sector may have an image problem, having kick-started the stock market collapse in 2000 that led to a three-year bear market, but investors are beginning to show interest again.

Amongst the professionals, an increasing number of fund managers have begun to welcome the sector back into their portfolios in recent months, helping to drive the UK Techmark Index to five-year highs of just under 1,500 points this week.

The Techmark is now up around 20 per cent over the past six months alone, while the US Nasdaq index - which comprises mainly of technology, media and telecoms stocks - has risen more than 25 per cent over the same period.

"The earnings growth forecasts for world markets have gone down to about 9 per cent for the next 12 months, but technology companies are still expected to grow their profits by 18 per cent globally over the coming year," explains Hitesh Thakrar, the manager of New Star Asset Management's Technology fund.

"Part of that is worked into the price, but some managers are starting to reassess portfolios and are gaining greater confidence in the technology sector. A lot of global portfolio managers haven't owned this sector for several years."

Thakrar believes it is the largest technology stocks that will perform best over the coming year. He points out that many of the bigger US businesses, such as IBM, Cisco and Hewlett Packard are now trading on similar valuations to other large companies. However, unlike their peers, they are predicting double-digit earnings growth for the year ahead.

Lindsay Whitelaw, the fund manager of Artemis's New Enterprises fund, agrees that valuations on many companies in the sector have failed to keep up with earnings growth. And he claims that there are a number of key drivers behind the current momentum.

"Demand from the corporate market is strong and going at quite a clip," Whitelaw says. "We've also got a new operating system out from Microsoft which is having a nice steady impact on the sector, and ratings are much lower than they were a few years ago. There's certainly no hope built into the ratings as there was previously."

However, Whitelaw warns that while the launch of Microsoft's new operating platform will have a positive knock-on effect across the whole sector over the coming year, certain sub-sectors are worth avoiding.

"I'm a bit wary of the semi-conductor and memory storage businesses," he says. "Their growth will be driven by the launch of Microsoft's operating system, which requires more memory. But stock markets have tended to over-react in the past when it comes to the effect of a new Microsoft platform on these companies."

Whitelaw's New Enterprises fund has been the strongest performer in its sector over both the past year and the past five years. However, every other fund has produced a negative return over the last 12 months.

Thakrar says that many funds have suffered at the hands of the strong pound and weak dollar. With two-thirds of global technology stocks listed in the US, many funds invest a large proportion of their portfolio on the other side of the Atlantic. With the shares of these companies bought and sold in dollars, UK investors have lost out when their fund has converted gains back into sterling.

By contrast, the New Enterprises fund invests 80 per cent of its portfolio in the UK, so has avoided the currency risk. Thakrar adds that with the dollar now near 15-year lows against the pound, the currency effect may work on the upside over the year ahead for funds that are predominantly invested in the US.

His major worry for 2007 is the mobile phone handset manufacturers which, after enjoying several years of phenomenal profitability, are now set for a slowdown in earnings growth.

Most investment experts believe that the best way for smaller investors to get exposure to the sector is through a fund. Thakrar points out that individual technology stocks tend to be more volatile than other companies, as sentiment plays a much bigger role - partly due to people's memories of the tech crash.

Stocks that trade on the highest multiples tend to get hit hardest when sentiment turns against the sector. However, he adds that the average technology stock is now trading on a price equivalent to just 19.5 times this year's predicted earnings. At the height of the technology boom, the average company was trading at around 70 times their future profits.

Meera Patel, a senior analyst at Hargreaves Lansdown, the Bristol-based financial advisers, urges investors who are considering investing in the sector to exercise some caution.

"Like any specialist fund, the decision to invest should be based on the level of risk you want to take and how much you believe in that particular market," she says. "It's worth remembering that if you've got a diversified portfolio, you'll probably already have exposure to technology through other funds that you hold. So you need to ask yourself how much more you really want. I certainly wouldn't advise anyone to have more than 5 per cent of their portfolio in technology."

It's certainly worth taking independent financial advice before taking the plunge. To find an independent adviser in your area, visit www.unbiased.co.uk.

The experts' picks

* Lindsay Whitelaw of Artemis says he has been a big fan of software companies over the past few months, particularly those who have business models where clients need to continue paying annual fees to the company - thus ensuring a recurrent earnings stream. Big performers in his portfolio have included the likes of Aveva, Royal Blue and Axon.

* New Star's Hitesh Thakrar says he is keen on Logica this year; it is trading at just 14 times its forecast earnings. "It has just made a big acquisition in Sweden and has strong operations in the UK, France, Holland and the Nordic regions. It should do well at this stage of the economic cycle." Thakrar also picks IBM, which he believes is undervalued.

* Cormac Weldon, the head of Threadneedle's US equities desk, says he believes the recent increases in corporate earnings will spark a rise in the amount of money that companies spend on IT this year, benefiting the likes of Cisco and Microsoft. He also likes Apple, which he believes will continue to enjoy above-average growth on the back of the enormous sales success of its iPod music and video players.

* For those looking for a fund manager to pick their tech stocks, Hargreaves Lansdown's Meera Patel recommends Artemis's New Enterprises fund; she says the fact that it invests in the UK makes it a slightly more defensive technology fund than many peers. She adds that its manager Lindsay Whitelaw has built up excellent relationships with the managements of companies in the sector and has a good nose for knowing when to invest.

* Patel is also recommending SocGen's technology fund, whose manager Allan Torry is one of the most experienced in the industry. She says she likes Torry as he is not a speculative hit-and-hope style technology fund manager. Instead, she says, he has a sound understanding of which technologies are likely to work in the market, and follows those companies that make products which he is convinced will be a hit with consumers. One of his current themes is high-definition television manufacturers.