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investing

Tech Titans are Cheap

Mega-cap tech companies are awash in cash and as profitable as ever. Yet they trade at low price-earnings ratios.

Benjamin Graham, the father of stock analysis, likened investing to doing business with a manic-depressive. In the late 1990s, Mr. Market lifted technology stocks to ridiculous extremes. Today, though, he is depressed when it comes to the group.

Take Microsoft (symbol MSFT). In 2001, it traded at 61 times earnings. On September 27, it closed at $24.73 -- just ten times estimated earnings for the coming 12 months.

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Microsoft is sitting on $37 billion in cash, and it generates roughly $24 billion annually in free cash flow (cash profits that are left after the capital expenditures needed to maintain a business). More than half of that comes from Windows and Office, which are profiting from a fresh round of PC buying by businesses.

Cloud computing -- doing complex computing tasks on the Internet rather than on PC-based software -- could hurt Microsoft and other mega-capitalization tech companies in the future. So could the move toward mobile computing. “Most of the largest technology companies are viewed as having limited growth prospects,” says Ken Allen, manager of T. Rowe Price Science & Technology (PRSCX).

But Allen says businesses are years from cutting back on buying new PCs. What’s more, the mega caps have billions to spend to acquire innovative companies and develop their own new technologies.

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If you’re concerned about cloud and mobile computing, consider Apple (AAPL), whose iPhone and iPad are huge beneficiaries of both trends. Apple is arguably the most innovative technology company in the world. It’s likely to remain so, at least as long as chief executive Steve Jobs, who underwent a liver transplant last year, stays healthy. Yet the stock trades at just 17 times estimated earnings.

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Qualcomm (QCOM) is another giant that benefits from mobile computing. It owns more than 10,000 patents in CDMA technology, which is used in wireless phones. It licenses its technology and makes semiconductors for phones. It has more than $15 billion in cash and, at $44.59, trades at 17 times estimated earnings for the next four quarters. In 2001, the stock traded at -- get this -- 5,000 times earnings.

An ETF for playing tech

Prefer funds to stocks? They offer diversification and require less monitoring. My favorite is Vanguard Information Technology ETF (VGT), an exchange-traded index fund. For just 0.25% in annual expenses, the ETF gives you exposure to tech stocks weighted by their market value (share price times number of shares outstanding). That means more than half of assets are in the ten largest tech companies, and 10% is in Apple alone. The Vanguard ETF’s holdings trade at just 14 times estimated earnings.

T. Rowe Price Science & Technology is a decent option. Allen took over its management only in early 2009, but he has been with Price for ten years. The fund returned 67.8% last year, about seven percentage points ahead of the average tech-sector fund. Year-to-date through September 24, it gained 7.3%, about half a percentage point more than its peer group. The fund has big stakes in all the stocks mentioned in this article.

The economy, no question, remains fragile. The recovery has clearly lost steam. But even during the depths of the recession, consumers showed a remarkable appetite for the new gadgets that companies such as Apple churn out. Businesses slowed their buying, but updating technology is one of the key ways companies can keep costs down.

Steven T. Goldberg (bio) is an investment adviser.

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