Tech stocks are making a comeback, but mutual fund investors don't appear to have noticed.Microsoft ( MSFT), which soared Friday after beating expectations with a 23% surge in quarterly earnings, isn't an anomaly. The truth is the technology sector has been back for a while. Year-to-date through Thursday, the average technology stock fund tracked by Morningstar is up 20.1%. Depending on how you look at it, tech is either the best-performing fund category holding U.S. stocks, or the third-best, behind natural resources and precious metals, two categories that are chock full of international equities. It's easy to see why: These companies have strong balance sheets, little debt, and sustained growth in a softening economic climate. Yet, not only are investors not adding to their holdings of tech funds; they've been actively pulling their money out. In the first nine months this year, investors pulled a net $2.9 billion out of tech funds, according to Morningstar. It's a measure of how far out of favor tech funds have fallen since the Internet bubble burst in 2000. Only two other categories of funds, large-cap growth and health care, saw bigger outflows this year. In fact tech funds are so unloved that money has been walking out the door for each of the past three calendar years, for a cumulative total of $19.6 billion.
Granted, tech stocks haven't been shooting the lights out nonstop. This year's surge is the first since the sector rocketing 56% in 2003. What's so surprising is that tech funds as a group have posted positive returns for each of the last four years, while simultaneously experiencing net cash outflows for the past three. Why the big disconnect? "It's a combination of investors having had such an awful experience with tech in the bear market and the fact technology has lagged other sectors such as natural resources, real estate and emerging markets," says Karen Dolan, fund analyst at Morningstar. "They were sitting in the red and people got sick of waiting around. People are just attracted to what is doing better and other parts of the market were more enticing." Dolan notes that investors typically do an awful job of timing the market, pulling money out of poor performing corners of the market and rushing into what is hot. "It's unfortunate, but it happens all the time, people buy and sell at the wrong times," she says. "People need to fight their biases and be willing to buy something that isn't the hottest part of the market and trim things that have done well. It's a healthy exercise that will help them avoid the pain they experienced with tech."
Ryan Jacob, portfolio manager of the ( JAMFX) Jacob Internet Fund (JAMFX) says, "I can understand the outflows. Tech has been doing well, but other sectors have been doing exceptionally well. But when you look at the lows of the market and the price of Internet companies in 2001 and 2002, if you had invested then, you would have made your money back and more." Jacob should know. His fund experienced the tech sector's highs and lows. During the bubble he and his fund became the poster child for the era's excesses and subsequent denouement. Opened just months before the bubble peaked, it quickly jumped 24% in three months, before plunging 96% to 44 cents a share in October 2002. But, while other Internet and high tech funds closed shop, Jacob held on. As of Thursday, the fund was up 572% from its all-time low. This year through Thursday, the fund was up 9%. Jacob says tech is no longer a value play and the risk of holding these stocks has increased along with the potential of a slowing economy. However, he thinks most tech companies can weather the storm as many derive a large percentage of revenues and earnings from overseas. To that end, the Jacob Internet Fund allocates more than 20% of assets to Chinese companies. His favorite China play is Sohu.com ( SOHU). This Internet portal is one of the country's leading media properties. Jacob says it should benefit from its exclusive position as the official Internet sponsor for the 2008 Olympics in Beijing. He says anyone on the Web who wants to use the Olympic logo needs to go through Sohu.
Even though most tech investors want growth, over the past five years, Jacob has balanced the fund between growth and value. He likes Earthlink ( ELNK) because it has a lot of cash on its books and trades at a low price to cash flow ratio. Jacob says while the Internet provider's core business has seen slight deterioration, two big investments have masked the general business' underlying cash flow. He says the stock is trading at four times net cash flow and feels it should be trading at six times cash flow. Another pick, Openwave Systems ( OPWV) is going through a restructuring that is depressing its value. The provider of infrastructure for the wireless industry is currently trading "well below one times sales and should be at least 1.5 times." Of course, you can't be an Internet fund and not own Google ( GOOG). Jacob says it's trading at 30 times forward earnings even as its earnings and sales are growing at twice that rate. "I think Google is moderately undervalued and the only way the stock will suffer is if it has deterioration in market position or in margins, which have been extraordinary," says Jacob. "You could make the reasonable assumption that the stock will be 40% to 50% higher a year from now."