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By Amey Stone It's next to impossible for a technology-sector fund to make it onto BusinessWeek's list of A-rated funds lately. That's because our rating system doesn't just reward funds for having high total returns over five years. It also gives them demerits for suffering major downturns along the way -- and the tech sector has seen plenty of those in the past two years.
Still, a tech fund made it onto our A-rated list in March: ICON Information Technology (ICTEX
). It has a three-year average annual return of 22%, while the typical tech fund has lost 7% a year over that time. So far this year, ICON's returns are flat, while the tech-laden Nasdaq is down 5% (see BW Online, 3/11/02, for the latest Mutual Fund Scoreboard monthly update).
It took a very unconventional strategy to enable a tech-sector fund to deliver top long-term returns without too much volatility. ICON Info Tech is what's known as a "quant" fund (for quantitative), meaning that lead portfolio manager Craig Callahan (a former finance professor at the University of Denver) uses sophisticated computer models to build the portfolio. The highly disciplined approach has helped him avoid getting caught up in stock market hype. "We buffer ourselves from rumors and scuttlebutt and emotions of Wall Street so we can make objective decisions," says Callahan, who runs the company from offices in Englewood, Colo.
KEY CALCULATION. The special sauce in Callahan's approach is a focus on rotating among different industries to catch them when they're out of favor with investors and just about to rebound (all the ICON funds are run using the same approach). Callahan believes industries stay in favor with investors for a year or two before wearing out their welcome (as judged by an expensive stock price).
Callahan's model calculates an "intrinsic value" for each stock using inputs that include historic earnings, expectations for future growth, and a measure for risk. Typical financial ratios like price-earnings or price-to-book value are too simplistic for his methods, he says. After calculating values for all stocks, "We just go through the portfolio over time, selling overpriced industries and buying ones that are underpriced," he explains. Morningstar puts the fund's turnover at 70%, about average for an equity fund.
To choose specific stocks, Callahan's team creates a basket of quality companies that are undervalued and will best represent that industry. They look for stocks that have low debt, plenty of cash, and use capital efficiently. "Financial statements can tell us that," he says. "We do not visit companies, talk to management, or look at brokerage-house research," he continues, with just a hint of disdain for those methods. He concedes he wouldn't know a semiconductor if he were handed one.
"OUT ON THE FRINGES." During the tech heyday in 1999, the fund was stocked with popular names like Qualcomm (QCOM
), Cisco Systems (CSCO
), Tellabs (TLAB
), and Applied Materials (AMAT
). He started selling a lot of them in early 2000, judging these shares too expensive, and switched into cheaper issues, often ending up in small, niche software plays. "We were still in technology, but we were way out on the fringes," he says. The strategy worked, and in 2000 the fund gained 14%, vs. the average tech fund's 30% loss.
In 2001, Callahan started buying battered semiconductor and chip-equipment companies. ICON Info Tech fell 13% that year, but the average tech fund was slammed, down 36%. This year he has stayed in semiconductor names like Microchip Technology (MCHP
) and chip-equipment maker Applied Materials, but he has decreased their percentages lately. He has added more from the application software industry (now 22% of the portfolio), with stocks like Take-Two Interactive (TTWO
), Verity (VRTY
), and Mentor Graphics (MENT
). System software makes up to 12% of the fund. Here Symantec (SYMC
) is a top holding.
Telecom equipment accounts for only 6.2% of the fund, but one stock there, voice-mail provider Inter-Tel (INTL
), is the largest holding at 5.4% of the fund. "If a stock stands out as a good bargain in a good industry and has the highest quality rating, we tend to take it up a little," says Callahan.
RELATIVELY STABLE. This year the fund has gotten more diversified and includes a much broader swath of technology names. Instead of emphasizing only 4 or 5 of the 12 technology industry groups as ICON Info Tech normally does, it now has 11 groups (all except Internet stocks). "We are about as broad now as we ever are," says Callahan, who is bullish on technology because he believes the economy is in the early stage of recovery.
One caveat: As well as the fund has done in the past two years, it didn't stack up quite as well against its peers when technology stocks were all the rage. It's almost absurd to complain, but in 1999, when ICON Info Tech gained 111%, its performance ranked in the bottom third of all tech funds. In 1998 it rose 34% but was in the bottom quartile of all tech funds. "Its relative stability during the downturns can more than compensate for the gains it leaves on the table during rallies," Morningstar's Alan Papier wrote in his analysis of the fund at the end of last year.
Assets of the no-load fund (widely available through discount brokerages) have grown to $235 million, up from around $200 million last September. Tech-sector funds are high-risk and certainly not for everyone. But if you're interested in adding a pure tech play to your portfolio without taking on all the risk of a typical tech fund, ICON Information Technology could be one to consider. Stone is an associate editor of BusinessWeek Online and covers the markets in our daily Street Wise column