When most investors think of the technology sector, semiconductor manufacturers and software firms are usually what come to mind. But that narrow conception belies the diversity of plays the tech sector offers. To discover the best opportunities within the sector, we spoke with Dave Carlsen, Elizabeth Jones and Clay Brethour, co-managers of Buffalo Science & Technology (BUFTX, 800-492-8332). The trio’s deep industry knowledge has produced one of the most successful technology mutual funds available, consistently ranked in the top third or better within its peer group.

Your team pursues an unconventional approach to the technology space. Please explain your perspective on the sector.

Dave Carlsen: We define technology as the application of human knowledge to solving problems and making life easier and more productive. That’s a fairly broad interpretation, but we think it points us toward all of the most innovative industries. We invest in information technology, industrial technology, energy technology and health care technology. So we look for industries that are either directly involved in research and development or are the beneficiaries of research and development or innovation.

As far as our investment process goes, we focus our top-down analysis on long-term sustainable trends. We’ve identified 26 trends that provide the growth thesis for all of our individual stock ideas. These growth trends include areas such as “capital for labor,” health care cost containment and Moore’s law. “Capital for labor” involves companies, such as software firms, that develop software or automation processes used to displace higher cost or more time-consuming human capital. And Moore’s law states that processor performance doubles every two years at the same unit of cost. We define our growth universe as companies that have one or more of these long-term trends as a tailwind.

Thereafter, we use a bottom-up approach by applying fundamental analysis to identify premier companies. We look for companies with sustainable competitive advantages, great management teams, scalable growth opportunities, high profit margins and solid balance sheets.

The third component of our process is our valuation approach. We take a disciplined approach to growth stock selection, which means the premium we’re willing to pay for a stock is dependent upon our model of both the magnitude and duration of a company’s growth. That’s how we qualitatively assess the attractiveness of business models. But it’s not a strict value approach to investing. Rather, it’s a tool that helps us better analyze growth stocks relative to one another.

How did the technology sector perform in 2011? 

Carlsen: The technology sector fell toward the bottom half of all sectors this year largely because we had such a strong run off the cyclical bottom in 2009. From there, the tech sector ended 2010 at a frothy level after a wide swath of the industry posted several quarters of positive earnings estimate revisions.

In the interim, both the European sovereign-debt crisis and the US’s inability to solve the country’s debt issues weighed on business and consumer confidence and tempered spending. As a result, technology spending, which tends to be discretionary, was impacted by falling expectations for future growth.

How has the broad technology sector weathered the weak economic environment?

Carlsen: In the decade since the Internet bubble burst, companies abandoned their non-core investment opportunities in favor of their core technologies. They’ve accepted the fact that technology no longer offers the massive growth to which they’d become accustomed.

The best companies preserved their balance sheets while weaker competitors faded away. The companies that survived this difficult period have solid balance sheets and sustainable competitive advantages. They enjoy high incremental profitability, wide profit margins and are pursuing growth opportunities in a more focused manner.

Does the sector have the financial strength to continue spending on research and development?

Carlsen: As I mentioned a moment ago, the technology sector boasts extraordinarily strong balance sheets. In bad economic times, a company’s revenue can ebb and flow with its sensitivity to the broad economy. But companies with strong balance sheets can continue to invest in research and development and pursue innovation even during downturns. Premier companies such as Oracle Corp (NSDQ: ORCL) and Cisco Systems (NSDQ: CSCO) can invest in new growth opportunities while companies with weaker balance sheets are forced to cut spending in these areas. And companies with solid balance sheets typically acquire their best talent during lean times. So downturns can actually afford financially strong companies the opportunity to develop long-term competitive advantages.

Tech investors are always chasing the next great innovation. How do you identify such opportunities?

Carlsen: We’ve found that focusing on quality companies is the best strategy. Firms with solid financials have the resources to attract the best talent and the balance sheets to pursue the best opportunities. So this focus allows us to uncover innovative firms without having to resort to jumping on the latest technology bandwagon. Our diversified approach also helps in this regard. And though we don’t chase innovation, we strive to keep abreast of any changes in the marketplace.

Where is your focus in the sector?

Carlsen: We prefer companies that demonstrate organic growth and avoid companies that depend on the rising macroeconomic tide.

In information technology (IT), we’re focused more on communications and mobility than the personal computer. In energy technology, we’ve focused on emerging-market resource consumption and alternative energy sources, such as liquefied natural gas.

Elizabeth Jones: In the health care space, we’ve targeted areas that don’t depend upon reimbursements. We prefer health care IT because these tools have yet to be widely adopted within the US health care system. We have limited exposure to the medical devices segment because there will be significant pressure on health care expenditures in the US and other developed markets. That could lead to lower utilization of some medical devices.

Within the pharmaceuticals space, we look for companies that offer products with a compelling cost benefit.

Can you tell us more about your approach to the energy technology space?

Carlsen: We’re focused on energy efficiency leveraged to emerging market growth, particularly with regard to such countries’ burgeoning middle class as well as globalization.

Developing countries have opened their markets to global trade. They’re building infrastructure to foster global trade and building out and attracting manufacturing. That’s created jobs, which has boosted incomes and contributed toward the development of consumer-driven economies.

There are four times the number of households in developing countries as there are in the developed world. And the International Monetary Fund (IMF) estimates that the emerging market middle class is equal to roughly 2.5 times the population of the US. As these consumers’ incomes increase, they’ll buy more discretionary items like computers, cell phones and automobiles.

Compared to their peers in the developed world, emerging market economies are far more fundamentally attractive marketplaces for broad economic growth. Their share of world gross domestic product (GDP) will increase substantially over time, so we want exposure to those marketplaces through great American companies operating in innovation-based industries.

Please tell us about one of your favorite energy technology plays.

Clay Brethour: China was responsible for 76 percent of the growth in energy demand from 2008 to 2010. Emerging markets will weigh heavily on the natural resources space. Next year, oil and gas companies are projected to spend close to $350 billion to extract more oil and gas from the ground. That’s a 12 percent increase from 2011. From our perspective, that type of spending is equivalent to what other industries might classify as research and development (R&D). For comparative purposes, drug R&D is about $100 billion annually. Because spending on energy exploration and development is more than three times as large, we want exposure to those capital expenditures. 

Chart Industries (NSDQ: GTLS) is one of the more unique energy plays within the industrial energy technology space and offers investors a chance to participate in the globalization of the natural gas market.

When people discuss energy and natural resources technology, the conversation inevitably drifts toward solar or other green-energy technologies. But solar companies have always struggled with the sustainability of their business model, particularly given their dependence on government subsidies. Costs will eventually fall to sensible levels, but they haven’t done so yet. It’s a dilemma we see throughout the alternative energy space. 

In the meantime, we believe that natural gas is the most logical “bridge” energy source, as it’s cleaner burning than coal or oil. Just 10 years ago, natural gas was typically flared off the wellhead if there wasn’t an ability to get it to market in a timely manner. It was originally a regional commodity that has since become a global commodity, primarily due to liquefaction technology, which has given producers the ability to transport liquefied natural gas (LNG) long distances. China is vastly increasing its energy usage and natural gas fits within the country’s energy policy.

Chart Industries is a small company based in Cleveland, Ohio, but it’s a global player in providing key components for the liquefaction process. The company has operated in that market for the past six years and the firm’s footprint continues to expand, particularly in Asia.

Shifting toward your fund’s focus on health care IT, what effect would the rollback of health care reform have on this space?

Jones: Of course, I can’t predict what the government’s going to do. While the Patient Protection and Affordable Care Act (PPACA) that was passed in 2010 gets most of the attention, the American Recovery and Reinvestment Act (ARRA) of 2009 allocated about $18 billion toward the rollout of health care IT and electronic medical records at hospitals and other facilities. So even if the PPACA is eventually repealed, that won’t affect the dollars allocated to health care IT by the ARRA; there would have to be a separate act to roll that back. In an environment where government budgets are under pressure, it’s still possible that such funding could get cut, so we’ve chosen to invest in areas of health care IT that are very underpenetrated.

As such, we’ve focused on those technologies that address the needs of smaller physicians’ offices, as opposed to larger enterprises that might have 100 or so providers. We also focus on companies that provide similar solutions to small hospitals. Electronic health records have yet to be widely adopted in these areas, and medical providers will need the ability to communicate electronically with one another, as well as with insurers and the government. Regardless of government spending in this arena, we expect significant growth in excess of GDP growth in those particular areas of the sector.

Health care IT is a fragmented market, with numerous providers of health record systems. How do you identify those firms whose business models have longevity?

Jones: We want companies that have developed their technology organically instead of cobbling it together from various acquisitions. We also look for companies that retain management of their systems instead of selling a facility hardware and software that they then have to manage themselves. Smaller physicians’ offices and smaller hospitals rarely have the budgets or expertise to manage such technology on their own. So we prefer a company that offers a subscription model where facilities pay a percentage of revenue toward the company to provide and maintain the system.

Please tell us about one of your favorite names in the health care IT space. 

Jones: Within the health care IT space, Athenahealth (NSDQ: ATHN) provides physicians with medical practice management and electronic health record platforms. It uses a cloud-based subscription model that’s very scalable and tends to work best with small physicians groups. The statistics available regarding the penetration of electronic health records in small doctors’ offices range from 10 percent to 25 percent; I think the real number is closer to the bottom of that range.

Athenahealth’s software reduces staffing needs by improving the functionality and productivity of the office. Instead of maintaining a few full-time billing specialists on payroll, a doctor’s office only needs a medical biller for a few hours each day. The company is usually paid 3 percent to 4 percent of physicians’ collections. 

Athenahealth has also connected its electronic health record platform to its practice management solution, so claims are prescreened by the system and then sent directly to insurers. When doctors’ offices send claims to insurers, generally 60 percent are sent back because the forms weren’t filled out correctly. With Athenahealth’s system, 93 percent of the claims filed with insurers clear that initial hurdle.

When physicians sign up for the service, the number of days outstanding for receivables drops from the 70s to the high 30s. So physicians’ upfront payment for Athenahealth’s solutions is quickly recovered just by reducing their receivables in those first several months. 

In addition, the system includes a communicator, which is an automated system for contacting patients before appointments, scheduling appointments and even collecting payments such as copays before a patient even arrives at a physician’s office. So that also leads to improved productivity in terms of lower patient no-show rates.

Carlsen: With more and more health care data being captured and digitized, it will eventually be a useful resource for physicians to use in determining the proper course of treatment. That’s a sustainable long-term trend that makes common sense.

What is your best advice for investors in 2012?

Carlsen: Investors should increase their allocation toward equities. Yield-seeking strategies and fixed-income markets are very crowded at the moment, while valuations of well-managed companies with healthy balance sheets and attractive growth prospects are far more compelling.