Managers say that careful selection may yield good buys.
Are technology stocks making a comeback?
In the second quarter of this year, tech stocks gained 8%. In addition dividend payments, though small, increased 44% over the past two years, according to Standard & Poor's. Meanwhile, technology stocks historically have declined during the early months of the year only to rally in the second half.
After trailing the broad market over the past several years, some analysts expect tech stocks to rally. Their price-to-earnings multiples are low in relation to future earnings.
"Technology companies are currently attractively valued on a historic basis as well as relative to the market as a whole," says Michael Sola, manager of the T. Rowe Price Science and Technology Fund.
But technology stocks have a long way to go before they make back their bear market losses from 2000 through 2002. Technology stocks have had six market plunges of more than 10% from 1987 through 1995, based on the Pacific Stock Exchange (PSE) Technology index. Five years following each decline, technology stocks, on average, have grown at a 24% annual rate, according to a study conducted by T. Rowe Price.
This time around, however, could prove different. The average technology stock fund lost 37.62% annually over the three-year bear market that ended in 2002. So it could take time for investors to make back losses.
It is uncertain whether technology mutual funds will accomplish this task in the near future. For example, during the fourth quarter bear market of 1987, the PSE Technology index lost 42%. Five years later, the average annual return on tech stocks was -1.6%.
The problem today: Technology companies have high operating margins. It's tough to expand margins in the face lackluster corporate spending, a strong dollar, rising oil prices, higher interest rates, geopolitical risks and new environmental regulations that affect European manufacturers.
Besides fundamentals, the industry is fraught with risk. Who can forget Wang Computer and Digital Equipment Corp., two high-flying, Massachusetts-based computer manufacturers? The companies went out of business or were acquired in a distress sale in the 1990s. No one knows for sure which technology companies will become obsolete today.
In addition, there is a lot of market speculation. Earlier this year Vicuron, a biotechnology company, was acquired at an 85% premium to its initial public offering price, according to the Medical Technology Stock Letter in Berkeley, Calif.
Despite some challenging conditions, T. Rowe Price's Sola is optimistic. During the first half of this year, consolidation of tech companies, such as Adobe Systems' acquisition of Macromedia and Sun Microsystems' purchase of Storage Technology, gave this sector a lift.
Another positive factor: Just-in-time inventory management has eliminated the semiconductor glut and reduced inventory-to-sales ratios.
"With large hoards of cash and attractively valued targets, the pace of consolidation will likely accelerate," he says. Despite the challenges in business spending, adoption of digital technology continues at a rapid clip. Consumers are embracing the rollouts of new products from high-definition televisions to cell phones with video capability. The demand for broadband is generating a demand for new and upgraded communications equipment."
Currently, more than half of the fund's assets are invested in software and semiconductor stocks. Another 25% are in hardware and telecommunication equipment.
Sola's largest purchases this year include Dell, eBay and Qualcomm, because the stocks represent good values based on future earnings. Meanwhile, he sold off positions of Intel, Qlogic and Texas Instruments.
No one knows for sure what will happen in the tech sector. A lot depends on investor sentiment.
But Liz Ann Sonders, chief investment strategist for Charles Schwab in San Francisco, says double-digit 12-month growth in earnings at the end of the second quarter of 2005 could be a harbinger of things to come. Technology stocks beat analyst earnings estimates by the widest margins of any sector. Plus, cyclical stocks in the information technology sector were expected to show a 17% growth in earnings in 2005.
"Technology stocks garner a lot of attention during earnings season," she says. "Overall tech earnings have been steady and will likely exceed 20%. In fact, technology companies that have exceeded expectations so far have done so by 6%, which is the best performance of any sector except telecom."
Meanwhile, Edward Yardeni, chief investment strategist for Oak Associates in Akron, Ohio, favors the semiconductor equipment sector. He is advising investors to overweight their portfolios in this sector. Reason: He expects strong earnings growth in 2006.
"The fundamentals are still weak, with forward earnings still stalling and bookings down 33% from a year ago. However, the stocks may be starting to anticipate a cyclical upturn in orders. Analysts are predicting a big drop in earnings this year, but a double-digit gain next year. The technical picture looks bullish for us."
Other sectors he recommends overweighting include: storage peripherals and systems software. These sectors are showing improvements in profit growth, unit sales, profit margins and operating earnings per share.
Demand for information storage has increased due to the threat of global terrorism, as well as the need for financial institutions to store client investment information.
Meanwhile, system software demand is increasing due the strong sales in digital cameras, cell phones and other consumer technology.
Like Yardeni, Cody Acree, managing director at Legg Mason Wood Walker in Baltimore, believes selected technology stocks will perform well because the economy is performing above expectations. He favors big outfits like Texas Instruments, Intel and Advanced Micro Devices. These chip manufacturers are the dominant players in the computer notebook market. Earnings of all three companies, he says, should grow more than 30% over the next six months.
Other technology stock fundamentals are improving. Steven Milunovich, technology analyst for Merrill Lynch in New York, has upgraded the communications, storage and Internet sectors to portfolio overweightings. He cites improvement in relative earnings growth, sales growth and upward earnings revisions.
By contrast, he has downgraded wireless, semiconductors, software and supply chain companies due to relative weakness in earnings, sales and other factors, compared with other sectors.
Stocks Milunovich recommends include Analog Devices, Broadcom, eBay, EMC and Amdocs. But he advises selling Infineon Technologies and Micron Technology, due to a number of earnings growth, valuation and technical factors.
Other money managers, however, are not convinced that it is the time to invest in technology stocks. They point to technical trend measures, such as relative strength and other stock-price-momentum indicators, as signals that it is premature.
"Tech stocks seem to be having a bit of a rally," says William Donoghue, editor of MarketWatch's Proactive Investor. "The moves are tempting investors. But with interest rates threatening to rise, the U.S. stock market is too vulnerable for a longer-term technology investment."
On the medical technology side, stock pickers favor small-cap companies. The Medical Technology Stock Letter reports strong short-sales activity in this sector. But the entire sector soared when Genentech announced positive test results for some of its drugs.
"Despite these strong moves in the big names, we believe that the smaller-cap biotechs remain undervalued, and most of them are potential acquisition targets," the newsletter says.
The report says that small biotechnology companies are the best values today. Companies such as AtheroGenics, Conor Medsystems, Incyte Corp., NPS Pharmaceuticals and Nuvelo Inc. could be subject to takeovers.
Not all technology stocks are attractive. Amy Arnot, a Morningstar financial analyst, says there are a number of overvalued tech stocks that should be sold. These stocks are trading at least twice as high as her estimates of the companies' underlying fair value. Stocks investors should consider selling include Apple Computer, whose earnings are at risk because of its dependence on new product launches, she says. Apple is expecting to revamp its product lines every few years. Such major product transitions are considered risky and costly.
Seagate Technology, she says, faces stiff price competition in the data storage market that is affecting earnings.
Sirius Satellite Radio is a start-up company that has a history of poor cash management, she says. The company faces stiff competition from XM in the digital radio market. Both companies could go out of business if consumers don't take to this new media.