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Want technology stocks?
Labour funds can feed hunger for tech stocks

Admittedly, not many people are real enthused about technology stocks or mutual funds these days. Over the last two-and-a-half years, the tech-heavy Nasdaq 100 stock index has fallen by more than 75 per cent. Ouch!

It seems to me, however, that investors have a love-hate relationship with tech stocks. They hate them right now because of the scorching losses; but they bid up the prices of this volatile group on the tiniest bit of good news. I say go ahead, buy technology investments; but here are three good reasons why labour sponsored investment funds (LSIFs) may be the best way to get your tech stock fix.

Valuations

My guiding thesis for my upcoming 2003 LSIF update (an annual instalment) is that the mauling of technology stocks in the public markets has had a ripple effect on the venture capital (i.e. LSIF) side of the industry to the extent that today may be a good time to buy.

(For our discussion, the terms LSIF and venture capital managers are used interchangeably.)

Recall that LSIFs usually finance private companies. While these companies may hold great promise for the future, they need a lifeline of cash from LSIFs until they can find a big company to come along and buy them; or get their shares to debut on a public stock exchange (i.e. IPO).

Since big public companies like Nortel, Lucent, and Cisco have been busy licking their own wounds for the past couple of years; they've not been in the mood to pay big money for the cutting edge technology of some venture capital technology firms.

Nor are LSIFs in a hurry to help their invested tech companies to list their shares for trading in a market that has kicked tech stocks in the proverbial stomach. What have the managers of LSIFs been doing?

They've spent most of the last two years nurturing the companies in which they've already invested. That means feeding them more money to bridge them to the point where the market environment is once again receptive to IPOs or acquisitions. It also means that only the quality companies that have the potential to be profitable are getting any real money these days from venture capital managers.

Also, both valuations and the structure of financing deals have moved more in favour of venture capital managers. The current environment is the antithesis of the tech euphoria that prevailed just three short years ago.

Bigger upside

Recall from our previous discussion of LSIFs that there exist three main sources of return in venture capital. In short, LSIFs earn a return on capital by:

  • bringing liquidity to an investment (i.e. via an acquisition or an IPO);
  • helping the business grow by tracking its business plan; and
  • having one of the Lucents of the world not only buy a company from a LSIF, but buy a controlling stake.

    The first point, liquidity, is potentially the biggest contributor to the total return on a private equity investment. (Though, a business has to remain financially and operationally healthy in order to attract the desired liquidity.) My point: this is a source of return that simply isn't available when investing in publicly traded stocks because they're already liquid.

    That doesn't mean you should drop everything and invest in venture capital quite the contrary. There are significant risks, but they can be worth taking when entered into prudently.

    (For a refresher on LSIFs, read this previous article )

    Repeating industry leaders

    Remember Big Blue? That was the nickname of IBM, which was the Microsoft of thirty years ago. IBM was a dominant technology player that was viewed by many as a firm that would occupy its envious position indefinitely.

    While IBM exists today and still has a good business, it is not the dominant player it once was. IBM's shares have appreciated by about 6 per cent annually over the past twenty years. Not exactly the stuff champions are made of. That's not a comment on the stock or the company. Rather, it's a sober reminder that: a) tomorrow's industry leaders may be unknowns today; and b) great investment returns won't result simply because you think today's industry leaders will survive for years to come.

    IBM is one well-known example, but suffice it to say that in the an industry where change is the only constant; it's naive to assume that today's leaders will still be standing on top of the hill in ten or twenty years from now.

    Investors need to be careful with LSIFs. Their big lure is the promise of generous tax credits. The credits exist because of the unique risks involved in venture capital and investors would be well advised to hold no more than about 10 per cent of their total portfolios in LSIFs.

    However, I also believe that the timing is right to invest in today's better LSIFs. Working Opportunity Fund, Vengrowth, and Capital Alliance Ventures are three of the best LSIFs you'll find, in my opinion, with a focus on technology. If you're interested and well suited to this unique asset class, consider buying them today and holding for a good ten years.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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