Technology investors need to be prescient but also require a high threshold for pain. The excitement — and profits — of a 60-fold gainer like Autonomy come hand in hand with spectacular capital destruction. Nortel Networks, worth $250 billion in 2000, crashed from $83 per share to under $1 in just two years, ravaging the portfolios of thousands of investors.

Now Philip Pearson and Anthony Burton, portfolio managers of the GLG Technology long/short equity fund, are bullish about the opportunities for investors arising from the onset of connected computing. Following the upheavals that trailed the switch from mainframe to personal computers in the late 1980s and then the internet boom a decade later, they see connected computing as a third wave of creative destruction unleashing a new phase of innovation.

“We keep saying it but we really do believe what we are seeing in TMT now is a once in a generational change that provides huge alpha opportunities,” Pearson and Burton wrote in a late July note. “If you asked us to guess we would say this will last another two to three years.”

Arrival of the MID
Driving the change is the rise of the mobile internet device or MID (see Fig.1). This is unleashing wide ranging forces across the capital equipment, software, hardware, telecoms and consumer electronics sectors. In turn, the GLG team expect a number of winners and losers to emerge. The potential losers in this revolution are easily identified. They are the technologies and companies that shaped the PC era over three decades: Intel and Microsoft, other PC markers as well as hard drive vendors and original design manufacturers that produce over 80% of PC notebook components.

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Take Microsoft. With a price/earnings ratio of around 10 the software giant is a value play for some hedge fund managers, including Greenlight Capital’s David Einhorn. Even Warren Buffet has recently called Microsoft “cheap”. But Pearson and Burtonbelieve that Microsoft and most other stocks in the PC Camp will provide disappointing returns to investors.

“To discuss one year’s P/E is flawed,” says Pearson. “It is not that valuation is unimportant. It is instead important to look at an addressable market and how it will evolve over four or five years. Apple and ARM, and others, are slowly destroying the business models of Wintel even though they are still making decent profits.”

The GLG pair carefully point out that they don’t expect the losers to blow up as connected computing continues to evolve and grow. Instead, their sense is that the stocks of earlier tech eras will behave like IBM, which in the 1990s fell slowly but relentlessly until the company had lost 80% of its market value.

“We are not arguing that Microsoft or Intel will disappear,” says Burton. “What we are saying is that they will be affected for maybe 10 years or more as the market they address gets smaller and they operate at lower (profit) margins.”

Apple triumphant
Turning to the winners, the most visible after Apple is ARM since it designs the chips that power the iPad and iPhone. Manufacturers of those chips, including Nvidia, is in the so-called ARM Camp, as is Samsung which is in a bitter lawsuit with Apple but still supplies it with chips and display panels. Google is also a winner, dominating search across PCs, tablets and smart phones and with Android, its smart devices software, may yet emerge as the outright champion in the space.

Another group of winners is what the GLG pair call the Arms Dealers. They include semiconductor capital equipment producers, telecoms equipment vendors and companies like Red Hat (software) and EMC (storage) benefitting from the growth in cloud computing. Social media is another winner, but with the exception of LinkedIn, is tough to play as sector leader Facebook isn’t yet a public company. Autonomy, however, is providing key software support to social media companies, while ad agencies like WPP and Omnicom have another media sector to sell through their digital sales operations.

At the core of team’s long book is, of course, Apple. Second quarter numbers out in late July blew away analysts’ forecasts, showing still accelerating revenue growth (up 82%) with profits more than doubling. Sales in China grew six-fold with the country now accounting for 25% of iPhone sales. For the GLG team, there is more to come as Apple builds share in developed markets and ramps up sales in emerging markets like India. Indeed, with Apple on a prospective P/E of about 15 and with $76 billion in cash and liquid securities, it is possible that the stock could double again.

A further source of short alpha for the strategy is European telecoms companies. They are being hit by consumer weakness, higher taxes, regulatory cuts on roaming revenue and rising competition from Skype and other low cost entrants. According to Pearson and Burton, their defensive merits aren’t as great as the market believes and the risk of dividend cuts and debt rating downgrades will rise in the next few quarters.

Risks to the strategy
What could upset the strategy or sap its investment performance? Burton and Pearson identify four chief risks.

Quite simply, Apple could blow it. Investors should remember that in 1987 Apple, with the original Mac, led the industry. But failures in execution saw the Wintel platform supplant the Mac, Jobs fired and Apple get shunted to the margins for over a decade.

Given the tepid economic climate in the US and Europe, consumer spending could prove vulnerable to undershooting. The GLG pair argue that enterprise spending will remain resilient, noting that Cap Gemini and Accenture are reporting a 15-year high in demand for project implementation and consulting services.

Perhaps the biggest risk to the strategy is Microsoft suddenly making dramatic moves that see it radically shift direction in an unpredicted fashion. A signal that this might occur could be the sudden firing of CEO Steve Ballmer – a course of action urged by Einhorn earlier this year.

A final, very plausible, risk is Android. Can it parlay Google’s record of innovation and deep pockets into dominance? Should Apple remain content with high margins and set product lines Android could yet get enough room to out-innovate it. With Samsung, Vodafone and Huawei, and many others, making Android-powered devices the competition to Apple can only grow.