Beyond Bulls & Bears

Equity

A Practical Approach to Tech Investing

Although the stock market seems to have regained its footing after a particularly volatile couple of months, it’s understandable that some investors may be nervous about investing in the technology sector, which has been known as an unpredictable area of the market. Matt Moberg, vice president and portfolio manager, Franklin Equity Group®, takes a long-term view of the technology sector, focusing on companies he believes can survive beyond temporary trends and speculative excitement. He offers his insights on the sector as a whole, and where he is finding specific opportunities today.

With the nervousness over geopolitical concerns, including a slowdown in the eurozone, ISIS in the Middle East and the US mid-term elections, we weren’t surprised to see volatility rile the stock market this fall. The equity market appears to have calmed down recently, and we attribute the relative tranquility to the announcement of generally positive economic news, such as decent US gross domestic product (GDP) growth in the third quarter, a drop in the unemployment rate, strong corporate earnings results and an expectation the Federal Reserve (Fed) will not likely raise interest rates until around mid-2015.

Amid the turmoil, technology was actually among the best-performing sectors of the market in the third quarter of 2014,1 driven primarily, in our view, by innovation, improving revenue growth, dividend growth and share repurchases. During October’s volatility, Internet stocks underperformed other segments of the tech sector, while hardware, software and information technology services outperformed.2

We expect that a favorable US economic environment could likely benefit technology going forward. In our view, the US economy is in the mid-cycle of its recovery from the 2008-2009 financial crisis, and record levels of cash on corporate balance sheets may contribute to future investment in new technology solutions.

The level of volatility within the technology sector may vary over time due to multiple factors. But volatility in the tech sector over the past few years has actually been lower than some other areas of the market (such as energy).3 Within the tech sector, more cyclically oriented sub-industries tend to feel the effects more if the economy shows signs of a slowdown, because corporations defer capital spending on technology projects to maintain cash flow in the short term. Technology is also a high-profile sector, attracting attention from both industry experts and the general public because key companies in the sector often create products that generate headlines due to market demand, such as new operating systems or smartphones. However, technological innovations with far-reaching implications sometimes do not attract large amounts of attention, particularly those that improve infrastructure or systems that are out of the public eye. We believe this is a great place for an active manager to add value by identifying innovative companies that are generally not being recognized by the broader market.

As long-term investors, we try to see past the short-term hype that often surrounds technology stocks and drill down into the product line or service that makes a company an interesting investment. We use bottom-up fundamental analysis to uncover investment ideas, seeking innovative, fast-growing companies that meet our criteria of growth, quality and valuation. Sustainable growth is vital, and we look for companies that we believe can maintain that growth for years to come.

Investing in Innovation

Today, the technology sector is ripe with innovation, and we’ve found a number of potential opportunities across myriad business segments. One area that we find exciting is e-commerce, which most people around the world are familiar with, even in emerging markets. In a nutshell, e-commerce connects buyers and sellers electronically, providing more efficient shopping experiences and allowing customers to access products they may never have had the ability to purchase before.

Alibaba Group Holding Ltd.,4 the parent company of three large China-based shopping sites, completed one of the largest initial public offerings in history this fall and is a major player in the e-commerce market. We are interested in Alibaba because we believe it has compelling long-term growth prospects that are driven by several factors. Overall consumption spending in China as a percentage of its GDP is significantly lower than in developed economies, such as the United States, the United Kingdom, Germany and Japan.5 We believe the Chinese government’s plan to increase domestic consumption combined with a lack of existing retail infrastructure, particularly outside of very large cities, creates an environment supportive of considerable growth for e-commerce. With Alibaba’s substantial market share in the Chinese e-commerce space, we believe the company will be a primary beneficiary of these trends.

Software as a service (SaaS), or cloud computing, is also exciting to us; we think it is absolutely changing the way software is delivered. Instead of installing and maintaining software on each individual computer, clients can access up-to-date software through any Internet-enabled device. In the long term, we think that companies will continue to offload applications to these cloud-based subscription models, which benefits both the provider of the software, as they receive a more predictable revenue stream, and the consumer, who gets a simpler and better experience than by using packaged software.

Social media is another area of interest for us. Not only is it revolutionizing the way people communicate with each other around the world, we also believe marketers have just scratched the surface when it comes to social media’s potential for advertising purposes. Facebook,6 for example, has several advertising initiatives underway, including its Facebook Audience Network, which extends the reach of Facebook advertising campaigns into third-party mobile applications.

Outside of traditional technology, health care is another area that we are always looking for new innovations to invest in for our portfolio. Recently, many companies have received US Food and Drug Administration (FDA) approvals for new drugs, which, in our opinion, have really advanced health care. We feel like the sector is moving from an era of treatment to an era of cures, as diseases that we could once only manage can now be eliminated through new compounds. One example is Gilead Sciences Inc.,7 which recently received approval for the first once-daily, single-tablet regimen to help cure Hepatitis C in as few as eight weeks, a dramatic improvement from prior treatment regimes.8 Additionally, we’re very excited about the prospects for genome sequencing, which involves decoding a patient’s DNA to identify specific genes which can influence which drugs would be most effective to treat illness.

We’re also keeping our eye on other industry trends and technologies that could prove promising in the future. One is 3-D printing, where applications include rapid prototyping for industrial applications or the cost-effective fabrication of customized medical devices. We’re also interested in the latest generation of LED bulbs. Like previous versions, the new models are more power efficient and offer a longer lifespan. Unlike the previous generation, however, they also can work with dimmers and are the same size as traditional incandescent bulbs, and provide a warmer light that older LED bulbs could not produce.

We believe the prospects for identifying and investing in innovative technologies across a variety of market sectors are bright. Technology has been, and continues to be, an area of change with significant opportunities for growth, in our view. We look forward to witnessing the evolution of the innovations noted above as well as those not yet on the horizon.

Matt Moberg’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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What Are the Risks?

Franklin DynaTech Fund

All investments involve risks, including possible loss of principal. The fund’s investments in fast-growing industries, including the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. The fund may also invest in small-capitalization companies, which can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies. These and other risks are described more fully in the fund’s prospectus.

Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. To obtain a summary prospectus and/or prospectus, which contains this and other information, talk to your financial advisor, call us at (800) DIAL BEN®/342-5236 or visit franklintempleton.com. Please carefully read a prospectus before you invest or send money.

 


1. Source: Morningstar, Inc. © 2014 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Statement covers the quarter ended 09/30/2014.

2. Source: FactSet, Russell Investment Group. See www.franklintempletondatasources.com for additional data provider information. Based on the Russell 3000® Growth Index for the month ended 10/31/2014. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. Indexes are unmanaged, and one cannot invest directly in an index. Past performance is no guarantee of future results.

3. Source: Morningstar, Inc. © 2014 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Volatility is measured by standard deviation and compares sectors of the S&P 500 for the 1-year, 3-year and 5-year periods ended 09/30/2014.

4. Alibaba Group Holding Ltd. common stock represented 0.79% of total net assets of Franklin DynaTech Fund, as of 09/30/2014. Holdings are subject to change.

5. Source: The World Bank, 2014.

6. Facebook Inc. common stock represented 2.18% of total net assets of Franklin DynaTech Fund, as of 09/30/2014. Holdings are subject to change.

7. Gilead Sciences Inc. common stock represented 2.45% of total net assets of Franklin DynaTech Fund, as of 09/30/2014. Holdings are subject to change.

8. Source: US Food and Drug Administration, 10/28/2014.