Tech Drives a Hard Bargain
With technology stocks down for a third straight year, many investors may be pondering whether the sector is--finally--becoming cheap.
Yet despite their slump over the last two months, many tech shares remain pricey based on basic valuation measures such as price-to-earnings ratios.
Microsoft Corp., for example, trades for 29 times the next fiscal year’s per-share earnings estimate and Cisco Systems Inc. commands 33 times its 2003 fiscal-year consensus estimate, based on a survey of analysts by Thomson Financial/IBES.
By contrast, the blue-chip Standard & Poor’s 500 index is priced at about 20 times next year’s estimated operating earnings.
Still, some portfolio managers say leading tech stocks are poised to benefit if the economy continues to recover this year and next, and could reward patient investors.
“Eventually demand [for tech equipment] has to pick up as the economy improves, and we’re getting closer and closer to that point,” said Fritz Reynolds, manager of Reynolds Blue Chip Growth fund in San Francisco. He believes the sector’s drubbing of the last two years minimizes the risk of further downside.
The tech-heavy Nasdaq composite index bolstered investor spirits last week by surging 8.8% to 1,741.39, its best weekly gain in more than a year. But it remains down 10.7% in 2002 and down almost two-thirds from its all-time peak in March 2000.
Looking ahead, earnings estimates for many high-quality tech companies could be too low, just as they were too high before the economy fizzled two years ago, Reynolds said. Typically when earnings are depressed, as they are now, stock valuations appear to be daunting.
What’s more, jittery analysts and company managers scarred by two years of pain could be reluctant to express optimism in their outlooks, he added, and so they may be keeping the earnings bar low.
Reynolds cautioned that even with big-name tech firms there is a risk of obsolescence--the danger that befell Digital Equipment, Data General, Wang Labs and many others over the years.
He recommends holding a basket of 10 or so, such as Microsoft, Cisco, Intel Corp., AOL Time Warner Inc., IBM Corp., Hewlett-Packard Co., EMC Corp., Oracle Corp., Dell Computer Corp. and Nokia.
But many other fund managers say they are finding better bargains in other stock sectors, including railroads, industrial gases, defense and housing.
Ron Muhlenkamp, manager of the Muhlenkamp Fund in Pittsburgh, said he has been adding to his holdings in the home-building sector, such as NVR Inc., Centex Corp. and Beazer Homes USA Inc. With P/E ratios of 10 or less based on 2003 earnings estimates, the stocks remain cheap despite a good run over the last year, Muhlenkamp said.
“We’re still not finding any value in tech stocks,” he said. “People are buying them based on faith, not numbers. We don’t buy hope or hype.”
Muhlenkamp, whose fund is up 7.8% this year, uses a two-step process to initially screen for stocks worth researching further. He seeks companies with a return on equity above the broad market’s average, currently about 13%; second, he wants to see a P/E ratio no higher than the ROE.
For example, he would pay a P/E of 25 for a stock, but only if the company were posting an ROE of at least 25%.
“We want good companies at a reasonable price,” he said. “Cadillacs are usually too expensive, but we’ll buy Buicks and Pontiacs when they go on sale. We won’t ever buy a Yugo.”
Muhlenkamp said he tweaks his definition of “fair value” as the economy changes. Today’s inflation of about 2% and longer-term interest rates of 5% to 6% are fairly tame by historical standards; if inflation were to rise, threatening to chip away at the value of future corporate earnings, he would adjust his scale, demanding lower stock P/Es than ROEs.
Tom McKissick and John Snider, who manage the TCW Galileo Large Cap Value Fund in Los Angeles, also have been favoring sectors other than technology.
The managers focus on companies whose return on invested capital is improving, which they say steers them toward firms with improving business fundamentals and away from value traps--stocks that are cheap for good reason.
Rail giant Union Pacific Corp. exemplifies the kind of stock the managers favor. “After a period of mismanagement, the railroads are now an improving business,” McKissick said. “They’ve figured out the scheduling. The boxcars are leaving 80% to 90% full, not 50%. These are the kind of steady, grind-it-out companies we like.”
Union Pacific’s return on invested capital dwindled from about 13% in the mid-’90s to 5% by the end of decade, McKissick said. In the last couple years it has improved to 8% to 9%, with further room to rise, he said.
Electronics maker ITT Industries Inc. is another example, Snider said: “They got out of the auto parts business in the late ‘90s, and now it’s a smaller--but better run--business.”
In the industrial gases sector, where consolidation and technological advances have improved fundamentals, Snider said, Air Products & Chemicals Inc. and Praxair Inc. fit the fund’s bill. Their portfolio is up 5.9% this year.
Large-cap growth stock manager Liz Ann Sonders of the New York firm Campbell, Cowperthwait said she has found plenty of stocks to buy this year based on her reading of business trends in tech and other sectors.
Lockheed Martin Corp., for example, should benefit from increased military spending, Sonders said. Consumers’ increasing shift toward discount retailers, and the Kmart Corp. bankruptcy, should benefit Target Corp., she said, also noting that the company is “earlier in its life cycle” than industry leader Wal-Mart Inc.
Medical products maker Baxter International Inc. is “making significant inroads in biosciences,” Sonders said, while consumer products giant Johnson & Johnson is having success with drug-coated stents, among other new products.
Sonders said she also has been finding “intriguing opportunities” in tech, although she has been choosy and has steered clear of the priciest names.
She has bought Electronic Data Systems Corp. and Automatic Data Processing Inc. With a P/E of 15 based on 2003 earnings estimates, EDS is especially cheap, she believes.
ADP can benefit if an improving economy means companies will need more payroll services, Sonders said, while EDS, which provides technology consulting and management services, should gain as companies strive to “spend efficiently” as capital investment revives.
