Markets
Tech is as Prickly as Ever
The market is scorching, but these five picks are not overheated.
By David Landis, Contributing Editor
From Kiplinger's Personal Finance magazine, April 2004
Advertisement
After a year of spectacular gains, technology stocks are again tempting investors. Sure, things ended badly four years ago, but now tech companies are offering more than pie-in-the-sky concepts and empty promises. Battle-tested outfits with realistic business plans are booking actual profits, thanks to a strengthening economy. With painful memories still fresh from the brutal 2000-02 bear market, investors are wiser and warier.
Or maybe it's déjà vu all over again. In 2003, the tech-heavy Nasdaq Composite index soared 50%. Leading the way -- shades of 1999! -- were Internet stocks, up 123%. Such hot concepts as nanotechnology and Chinese Internet portals stoked speculative fever. Some of the biggest gainers have been companies with sexy stories and no profits -- for example, Nanogen, up 720% over the past year, and Netopia, up 633%. Many other big winners had been left for dead after the bear market and, therefore, had the most to gain from the rally that began in March 2003. Lucent Technologies, for example, now trades at $4, up more than 200% since last spring and up almost ten times over its 2002 low. Analysts no longer predict that Lucent, once a $63 stock, will drop to zero.
Improving picture
A healthy economy is the engine driving the surge in tech stocks. "A lot of companies got lean and mean, and now that tech spending is on the increase, the survivors out there are gaining from tremendous sales momentum," says John Buckingham, manager of the Al Frank fund, which posted a 78% return in 2003, thanks, in part, to tech stocks. Industrywide sales growth is expected to hit 10% this year, up from 5% last year. The falling dollar, a boon for an export industry such as technology, is translating into extra profits. Consumer spending at home is spurring a healthy market for flat-screen TVs, camera-equipped cell phones, digital cameras and digital-music devices. Corporations are no longer so tightfisted these days.
The result is a much-improved profit outlook, which, tech bulls say, justifies the run-up in share prices. In fact, says Sanford Bernstein strategist Vadim Zlotnikov, the sector's overall price-earnings ratio (based on 2004 earnings forecasts) rose only 3% in 2003, compared with a 15% rise in the P/E of Standard & Poor's 500 stocks. In other words, tech-company earnings rose nearly as fast as investors' expectations.
But even if tech P/Es haven't risen appreciably, neither have they collapsed. "The stocks look outrageously expensive," says Richard Bernstein, chief U.S. strategist for Merrill Lynch and a longtime tech skeptic. Overall, he says, tech stocks trade at 33 times projected 2004 earnings. By contrast, the S&P 500 trades at 19 times earnings. Although the premium might be justified if tech companies generate faster-than-average profit growth, Bernstein cites a Merrill Lynch study indicating that nearly half grew at a slower rate than average during the past decade. "That shows how people's perceptions and reality diverge," he says.
On tenterhooks
The fragility of the tech rally became clear in early February after Cisco Systems reported profits and sales that topped analysts' expectations. But the networking bellwether said that corporate customers remained "surprisingly cautious" about capital spending. Cisco shares sank nearly 9% in a single day, and the Nasdaq Composite dropped 2.5%.
In this market climate, the keys to success are to invest in companies that will benefit from emerging trends and not to overpay for their shares. Kevin Landis, chief investment officer of Firsthand funds, says one such stock is UTStarcom (UTSI). The Alameda, Cal.-based company offers low-priced mobile-phone technology that is particularly attractive to developing nations, such as China (where it is the leading wireless provider) and India. The company, which had sales of $2 billion in 2003, has a backlog of $1-billion worth of work. At a recent price of $34, the stock trades at a reasonable 18 times the average of analysts' earnings forecasts for 2004 of $1.91 per share, according to Thomson First Call. The stock, Landis says, "has a bit of an undiscovered-story discount to it."
Landis also likes disk-drive makers Maxtor (MXO) and Western Digital (WDC), which both are trading at about $10. They represent, he says, a bet on continued strength in personal-computer sales. The number of PCs shipped increased an estimated 11% in 2003. But even if PC sales stall, disk drives are increasingly finding their way into consumer products, such as TiVo-like video recorders. Maxtor trades at 13 times 2004 estimates of 77 cents per share, and Western Digital sells for 11 times projected calendar '04 profits of 97 cents per share.
WebEx Communications (WEBX) is a force in a high-growth area: the outsourcing of jobs overseas. Its technology lets workers in remote locations conduct Web-based video conferences and share documents and computer applications. This isn't an as-needed business, though: Most of WebEx's revenues come from monthly subscriptions, and renewal rates are a healthy 85%. In February, the company said 2004 profits could rise as much as 35%, which sent shares surging. They now trade at a not-so-cheap $25, or 29 times expected 2004 earnings of 85 cents. Still, there's room to grow, particularly as a provider to foreign-based companies, which now generate just 6% of revenues. Wells Fargo analyst Casey Ryan targets a 12-month price of $32, citing WebEx's leading share of the Web-conferencing business.
After trailing most other tech sectors last year, some software stocks appear to be cheap. One of the most notable underachievers has been Microsoft (MSFT) -- its price barely budged last year and is stagnant so far this year. Many investors have been spooked by a steady decline in its deferred revenues from software subscriptions, an indicator of future business. Revenues in the quarter ended December 31, however, were up a robust 19% from a year ago, and Microsoft raised its future-earnings projections for the second quarter in a row. Given that performance, its shares, at $27, look more than reasonable, trading at just 22 times average earnings estimates of $1.21 per share for the 2004 calendar year. That's barely above the S&P 500's P/E. And Microsoft still has an astounding $53 billion in the till.
--Reporter: Amy Esbenshade