How to Play the Tech Revival

It has been a wrenching decade for technology stocks. Investors still haven't forgotten the folly of the bubble that swelled to a peak in 2000 and deflated painfully over the next two years. Although operating earnings for tech companies have risen 90%, on average, since 2003, share prices have mostly stagnated since a short-lived rally that year.

Lately, though, tech stocks have shown signs of life, surging 26% since late July. For all of 2006, however, the sector gained an unspectacular 8%, trailing the return of Standard & Poor's 500-stock index by eight percentage points.

Still, the rally could have legs if analysts are right and tech companies generate 21% earnings growth this year, a gain that would surpass that of any other sector. What accounts for the optimism? Look around you. Sales of high-definition TVs, iPods and smart phones are booming, and that's just one sign of strong consumer demand for technology -- not only in the U.S. and other developed nations, but also in India, China and other emerging economies.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Also, businesses are finally upgrading their tech infrastructures after a long period of hesitation. "Everything they put in their networks in 1999 is obsolete right now," says Chris McHugh, a technology analyst with Turner Investment Partners. ÒThere's significant pent-up demand.Ó Tech shares aren't cheap, trading for 24 times trailing 12-month earnings. That's up from 22 in 2005 but well below 2003's price-earnings ratio of 40. A P/E of 24 is not outrageous, but this clearly isn't a growth-at-any-cost kind of market. Here are seven tech stocks that we think have the right mix of growth and attractive share prices. We're upbeat about two warhorses (Apple and Microsoft) and also suggest three funds.

Still an online force

Cisco, Intel and Microsoft are a few of the tech giants that fell out of favor when they became too big to post the kind of sizzling growth to which investors had become accustomed. To that long list you can now add eBay (symbol EBAY). Its forecasted 20% revenue growth this year is one-third the firm's five-year average. Shares of eBay are 49% off their 2004 peak.

But eBay still dominates not one but two rapidly growing global businesses. Its online-auction market is four times larger than any rival's. And eBay owns PayPal, the biggest online-payment business. The San Jose, Cal., company's cash hoard of $3.7 billion and its free cash flow (net income plus noncash charges minus capital costs) of nearly $1.7 billion in 2006 leave it with plenty of options to offset slowing growth in the U.S. auction business. EBay is buying back stock, expanding into fixed-price online shopping (Shopping.com and eBay Express), and penetrating classified advertising through its stake in Craigslist.org and its ownership of several foreign classified-ad sites. Meanwhile, the core auction business continues to grow rapidly overseas.

Shares of eBay trade at 24 times estimated 2007 profits. That's well below historical P/E levels and reasonable for a company that continues to dominate its markets and offer robust, if not mind-boggling, growth.

Printer maker

Talk about mundane. Zebra Technologies (ZBRA) is the leading maker of the hardware that prints bar-code labels for a myriad of uses, including inventory tracking, package delivery and baggage handling. The company, which went public in 1991, has sold more than five million printers. U.S. sales have been sluggish lately, though, and Zebra's shares are 18% below their year-ago high. But thanks to the increasing penchant of businesses and government to tighten security and collect and track data of all sorts, Zebra's future looks bright.

Hospitals are adopting bar-code technology to reduce errors in dispensing medicine. Businesses, notably Wal-Mart, use bar-code labels with built-in radio-frequency transmitters to provide real-time information on inventory levels. Vernon Hills, Ill.-based Zebra also makes printers that produce ID cards and drivers' licenses, as well as digital photo printers used in Kodak-branded kiosks.

Morningstar analyst Rod Bare expects Zebra to see annual revenue growth of 12% in two years, up from its current level of 6% to 7%. He thinks Zebra's shares are worth $45, or 25% more than their recent price.

Specialized chips

Investing in semiconductor stocks is risky because prices of computer chips tend to swing widely over time. One relatively safe play is Linear Technology (LLTC). The Milpitas, Cal., company specializes in analog chips, which translate physical conditions, such as sound and speed, into signals that can be read by electronic devices. For example, Linear chips regulate and monitor the battery-charge level in Apple iPods. They're also found in laptops, mobile-phone handsets, medical devices, automotive electronics, and military and space systems.

Analog chips are more specialized than their commodity-like digital counterparts, but they require less capital investment to produce and their prices are steadier. Linear focuses on higher-end, proprietary designs, a category in which prices are even more stable. It is one of the most profitable chip makers, with operating profit margins above 50%.

Fears of a slowdown in consumer spending and in wireless infrastructure spending, a key market, have taken a toll on Linear and other chip stocks. But over time, Standard & Poor's analyst Clyde Montevirgen says, sales in the high-end analog-chip category will grow faster than sales of other kinds of semiconductors. Analysts expect 20% annual profit growth from Linear over the next five years. The firm holds $1.8 billion in cash and pays a 60-cent annual dividend -- resulting in a 1.9% yield. Montevirgen thinks the stock, which is 23% below its 2005 high, could be worth $37 in a year.

Traffic manager

Shares of telecommunications-equipment suppliers imploded when the tech bubble burst, exposing a glut of gear and capacity throughout the phone industry. Even now, with demand for wireless and broadband technologies growing, it is a tough business to make money in because the number of big customers is shrinking. For example, with AT&T's acquisition of BellSouth, only three of the seven original Baby Bells remain. But we think investors are too pessimistic about Tellabs (TLAB), which trades for 19 times expected '07 earnings, down from a five-year average P/E of 29.

Almost 40% of Tellabs' business involves selling equipment that helps phone companies manage traffic along their networks. Its flagship product is a high-speed switch that will help prepare existing networks to support next-generation wireless technology known as 3G. Its other major business is sales of products that enable phone companies to deliver bundled voice, video and high-speed Internet service over fiber-optic networks.

A variety of factors could bog down phone-company purchasing decisions and make Tellabs' results volatile. But Jim Kelleher, an analyst at Argus Research, says that the Naperville, Ill., company should produce long-term earnings growth of 12% a year and that the stock's P/E should rise closer to historical levels. He pegs the value of Tellabs' shares at $18 to $19 -- significantly above the recent $11 level.

Computer protector

The networked computing world is infested with all sorts of dangers -- from viruses, spam and spyware to e-mail fraud and identity theft. As the top seller of security software, Symantec (SYMC) should be sitting pretty. But since it acquired Veritas, a maker of storage software, in mid 2005, its shares have stalled. Symantec highlighted its digestion problem when it disclosed that results for the December '06 and March '07 quarters would be shy of expectations. The stock sank to $18, nearly 50% below its 2004 high. At current levels, the stock may tempt bargain hunters.

The $13.2-billion Symantec-Veritas deal created the world's fourth-largest independent software company. But the process of integrating the two companies alienated many customers and confused investors, who weren't sure how the companies' product lines complemented one another. But it has positioned Symantec well for a future in which corporate technology managers are required to protect ever-growing amounts of data. The company's products include software for backing up and archiving data, as well as products that make it easier and cheaper for corporations to enforce security policies across their networks. In addition, companies increasingly want to buy their technology from fewer and larger vendors, a trend that should vindicate the Symantec-Veritas strategy.

Although Microsoft is renewing its push into security software, experts say Symantec is secure for now. Microsoft doesn't bundle its consumer-PC security program, OneCare, with Windows and must battle for retail shelf space. But its corporate security products could erode Symantec's lead over time.

Remote-access champ

If you're a telecommuter, you may be familiar with Citrix Systems (CTXS), which dominates an important niche. Its products allow businesses to place software applications on a centralized computer that employees can access from almost anywhere via an online connection.

Citrix is ubiquitous in the corporate computing world, and its flagship product, the Presentation Server, provided most of its software-licensing revenues during the most recent quarter. When Presentation Server revenue was unexpectedly weak in last year's third quarter, many investors took it as a sign that the business was declining.

Thanks to a number of acquisitions since 2004, though, Citrix's results are bolstered by a suite of complementary products with fast-growing sales. Revenue from products that enable online meetings and seminars, for example, grew 49% in the third quarter. Analyst Manuel Recarey, of Kaufman Brothers, an investment bank, predicts that revenues from these new businesses will grow an average of 40% this year and that Presentation ServerÐrelated sales will rise 10%. And although Citrix trades for 20 times estimated '07 profits, the stock's P/E, he notes, has generally ranged from 22 to 29 over the past five years. He expects Citrix's stock to rise to $37 over the coming year.

Patent play

While cell-phone makers are battling to entice buyers with new bells and whistles, a little-known company stands to gain no matter which brand comes out on top. InterDigital Communications (IDCC) owns more than 6,000 patents on wireless technologies. Founded more than 30 years ago, it has pocketed more than $1 billion in royalties, primarily from the sale of cell phones. Owning intellectual property is a marvelous business because there is no manufacturing cost and no inventory. InterDigital, which had close to $500 million in revenues last year, employs just 320 people, mostly engineers with advanced degrees.

Still, the business is not without risk. Persuading manufacturers to honor patents can be an expensive process that sometimes requires filing lawsuits. Big one-time patent awards can make revenues irregular, and a slowdown in cell-phone sales is, of course, bad news. InterDigital typically collects 1% to 3% of the wholesale price of a phone.

The stock fell 20% in December after InterDigital warned that revenues for the fourth quarter would fall short of expectations. But the mid-January share price of $34 represents a good opportunity as the industry makes the transition to the new 3G standard. InterDigital says its goal is to collect royalties on the sale of every 3G handset (up from 35% to 40% currently). In the best-case scenario, the company says, it would see $1.4 billion in 3G revenues annually by 2010.

The three best tech funds

As anyone who owned technology funds during the 2000-02 bear market knows, they are among the most volatile on the planet. Still, owning a fund should be less risky than buying one or two individual tech stocks. We consider the following three funds to be the best in the category. With tech stocks on the mend, you can use any one of them to boost returns without having to worry about picking individual companies. Just be sure to use them sparingly.

You'll be hard-pressed to find more-experienced tech-stock pickers than Walter Price and Huachen Chen of Allianz RCM Technology. Each has invested in tech stocks for more than 20 years. In 1995, the duo launched RCM's institutional shares, which returned 15% annualized over the past decade to January 3. Those results beat other tech funds' returns by an average of eight percentage points per year. Price and Chen buy shares of U.S. and foreign companies that they think can rise at least 50% in the next year or two. The fund's 47 holdings, a mix of blue chips and more-speculative stocks, include Nintendo, Google and Microsoft. RCM's newer D shares (symbol DGTNX; 800-223-2413) are available without a sales charge through discount brokers. Annual fees of 1.64% are slightly less than the average for the category.

A more diversified choice is Fidelity Select Technology. At last report, the $1.7-billion fund (FSPTX; 800-544-8544) held shares of 108 mostly large and midsize companies in various technology sectors. Charlie Chai, who took the fund's helm in January, had managed a similar fund, Fidelity Advisor Technology, for two years. Chai is supported by Fidelity's deep bench of analysts. Select Tech, which sports a modest expense ratio of 0.93%, returned 12% annualized over the past two years, a bit more than the category's average.

Exchange-traded funds, which trade like stocks, are a cheap and simple way to add technology to your portfolio. Technology Select Sector SPDR (XLK), for example, holds the tech stocks in Standard & Poor's 500-stock index. Its ten biggest holdings, which include Microsoft and Cisco Systems, account for more than half of assets. Boosted by a slug of telecommunications stocks, the ETF returned 12% in 2006, five percentage points more than the average tech fund. Rounding out its appeal is a minuscule 0.26% annual fee.

Key numbers: The scoop on seven promising tech stocks

With the exception of eBay and Symantec, our picks are all midsize companies. Companies of that size can still grow rapidly, but they are generally strong enough to withstand technology downturns.

Data to January 17. *In the past 12 months. **Estimates for 2007 calendar year. #For the fiscal year ending June 2008. ##For the fiscal year ending March 2008. Source: Thomson One, Yahoo.