Best And Worst Funds: Information Technology Sector

by: David Trainer

Information Technology is my top-ranked sector. As detailed here, only it and the Consumer Staples sector get my Attractive rating. Sector ratings, like fund ratings, are based on aggregation of my ratings for each of the stocks. All other sectors are rated Neutral or Dangerous.

The tech sector has a uniquely strong competitive position versus all other sectors. I think of it as a play on growth opportunities within every sector. What industry does not rely on technology for some part of its operations? Technology is embedded in nearly everything we do. There are exceptions, but that list is shrinking as technological innovation is making processes and things better all the time. The bottom line is the best companies are those that innovate the most, and technology companies are the most innovative companies by a wide margin.

There are 170 funds to chose from within the Information Technology sector, and they are all very different. Per Figure 1, the number of holding varies widely (from 17 to 421), which creates drastically different investment implications and ratings.

How do investors pick the right fund out of the sea of choices that will deliver the best returns?

Figure 1: Funds with Most & Least Holdings - Top 5

Sources: New Constructs, LLC and company filings

To identify the best funds within a given category, investors need a predictive rating based on analysis of the underlying quality of stocks in each fund. See Figure 2.

Our predictive fund ratings are based on aggregating our stock ratings on each of the fund's holdings and all of the fund's expenses. Investors deserve forward-looking fund research that is comparable in quality to stock research.

Investors should not rely on backward-looking research of past performance for investment decisions.

Figure 2 shows the five best and worst-rated funds for the sector. The best funds allocate more value to Attractive-or-better-rated stocks than the worst funds and vice versa, except for STPAX. This fund gets a Dangerous rating despite a sizable allocation to Attractive-or-better-rated stocks because its total annual cost is a whopping 6.9%.

One of my favorite stocks in the Technology sector is Google (NASDAQ:GOOG), which gets my Very Attractive rating. Google is the world leader in analyzing and synthesizing information, and I believe their skill set is the preeminent business skill set for the 21st century. Making sense of the mass of data and information floating around in cyberspace is a big job, and there is a lot of money to be made for those that are most proficient in doing that.

One of my least favorite Technology stocks is Verisign (NASDAQ:VRSN), which gets my Very Dangerous rating. The stock is expensive and its reported earnings are misleading. The current stock price ($36.52 as of close on 1/24/2012) implies the company will grow its after-tax cash flow (NOPAT) by 15% compounded annually for nearly 10 years. Those are high expectations for a company whose average growth rate over the last five yeas is -19%. Making matters worse is management's poor capital allocation track record. Since 1998, the company has piled up over $15 billion (after tax) in asset write-downs, which means management has written off over $10 for every $1 on its books. That is serious shareholder value destruction. Against that backdrop, it is hard to bet on 15% compounded annual growth in NOPAT.

Figure 2: Funds with the Best & Worst Ratings - Top 5

* MF designates Mutual Funds and ETF designates Exchange-Traded Funds

* Analysis uses the top-ranked or worst-ranked class for each fund

Sources: New Constructs, LLC and company filings

Investors need to tread carefully when considering Information Technology funds as most are not worth buying. Only 14 of the 170 funds for the sector allocate enough value to Attractive-or-better-rated stocks to earn an Attractive overall rating. Figure 3 shows the rating landscape of all ETFs and mutual funds in the Information Technology sector.

Figure 3: Separating the Best Funds From the Worst

Sources: New Constructs, LLC and company filings

Figure 4 offers additional details on the quality of funds in the sector.

Figure 4: Information Technology Fund Landscape Details

Sources: New Constructs, LLC and company filings

Figure 5 lists our Predictive Fund Rating for the 5 largest and most popular Information Technology funds.

Figure 5: Five Largest Information Technology Funds

* MF designates Mutual Funds and ETF designates Exchange-Traded Funds

* Analysis uses the top-ranked class for each fund

Sources: New Constructs, LLC and company filings

Disclosure: I am long GOOG.