Time to Buy Tech Again -- Carefully

MARCH 29, 2001



MASTERS OF INNOVATION


Time to Buy Tech Again -- Carefully
If you stick with the big caps, buy gradually, and stay the course for at least a year, you should see strong returns
If you watched tech stocks fizzle like a wet firecracker on the Fourth of July and are trying to figure out when you should jump back into the market for them, I have one word for you: now.

Like most people who try to call the market, however, I'd like to hedge that: Now's the time to buy tech stocks as long as you do so gradually and can hold on to them for at least a year. And the names you should be considering are the big-cap stalwarts that will be the acquirers in an industry consolidation. But even before any merger wave starts rolling, the market is going to cover more vertical ground than an elevator in the Empire State Building.

WITHIN SIGHT. So, why tech, and why now? Because after a year of regular beatings, tech stocks finally have been subdued by the market (click here for a BW Video Roundtable on the future of tech). "[Tech] stocks today are 58% off their peak," says Charles Boucher, semiconductor analyst at Bear Stearns. "If they go as low as the trough of 1998, they'll drop 65% from their peak." That means there's still potential for some techs to go lower, particularly telecommunications stocks, but also that the bottom is within sight, according to Boucher. And the fundamentals underlying the tech sector are slowly, subtly starting to improve.

For starters, tech spending may be taking a breather, but it's by no means dead. Although corporations are cutting capital expenditures as they struggle to absorb the impact of the economic slowdown, they still have compelling reasons to adopt new technologies. "Innovation continues," points out Megan Graham-Hackett, director of technology research at Standard & Poor's equity group. "There are new operating systems, new chips, and new Internet devices that can help companies improve their cost structures." On the consumer side, increased exposure to the Internet will drive the desire to reach the Web from different devices.

The tech subsectors that most analysts believe will come back first are semiconductor and hardware stocks (for an audio interview with Firsthand Funds' Kevin Landis on the outlook for tech stocks, click here). "These were the first companies to warn, and then the tech wreck filtered to telecommunications, storage, software, and services companies," Graham-Hackett says. "We've had a rolling bear market in the tech sector, and the theory goes that the first to correct will be the first to recover."

UBIQUITOUS CHIPS. It isn't only because chips led the way down that analysts are betting on their recovery. It's also because computer chips are in nearly everything nowadays, from your blow-dryer -- a chip regulates the power supply -- to your car to the vending machine at your office. If anything, the demand for low-end chips is increasing as they're used to manage more and more processes. "Semiconductors are a key component of all kinds of technology," says Brian Marshall, senior semiconductor analyst at JP Morgan H&Q. "Chipmakers aren't going away like dot-coms are." (For Lord Abbett analyst Milton Ezrati's tech roundup, click here.)

Of course, they still have business cycles. About one-third of semiconductors are sold to the PC market, which had a significant slowdown last year after several years of hypergrowth. It appears, however, that the decline in demand for PC chips may be leveling off. In part that's because PC makers are working off their inventories: Both Compaq (CPQ ) and Apple (AAPL ) had supply buildups of more than 10 weeks in early December. By mid-January, the period had been cut to five weeks, according to S&P's Graham-Hackett.

At the same time, consumer demand for PCs could be headed for a rebound. During the Internet boom in 1999, a lot of people bought PCs, which will hit their third birthday in 2002. Just as people generally trade in their cars after four years, they tend to upgrade their PCs after two and a half years, according to Graham-Hackett. They can't trade in PCs, so they pass them on to their kids -- who by now are using six-year-old PCs. These dinosaurs can't handle most of the software currently on the market, as parents are acutely aware. So a big test of consumer PC sales will be back-to-school buying in the third quarter, Graham-Hackett says.

GOOD BUYS. How can you take advantage of these trends as an investor? You could start with Dell (DELL ) and Intel (INTC ), two stocks that look to be trading cheap. It's true that at 34 and 43 times 2001 earnings, respectively, Dell and Intel's price-earnings ratios are higher than those of the broader markets. But once the carnage is over, most tech stocks should settle between 40 and 50 times forward earnings, according to Harry Dent, president of money-management advisory firm Harry S. Dent Foundation. That makes Dell and Intel pretty good buys compared to their peers.

"Dell is the best-positioned name out there [in PCs]," says Bear Stearns' Boucher. "It's able to respond quickly to market conditions, and it has increased its corporate business significantly." As for Intel, Boucher points out that its price-to-trailing-revenue multiple, which he relies on in periods of economic turmoil when earnings are hard to forecast, has dropped to near-1998 levels. "That suggests minimal downside risk," he adds.

If blue-chip names such as Intel and Dell sound almost Old Economy, that's the way things are in the postdot-com tech sector. Even in telecom, which will be among the last subsectors to recover, the growth potential lies in the Baby Bells more than in the myriad local-exchange carriers that sprang up overnight when the market couldn't throw enough money at telecoms.

SPELLING SHAKEOUT. Before lasting good news arrives for telecom investing, however, there's bound to be more pain. Of all the tech sectors, this is the one that analysts point to as still having excessively high stock prices. The problem is that there may well be more fiber-optic cable capacity than there is demand for it. That spells shakeout. The survivors are likely to be companies like Verizon (VZ ) that are using their high-end fiber-optic networks to sell broadband services such as DSL.

"Overall, network utilization is rising, and telecommunications companies will be forced to buy more equipment," says Chris Pasko, managing director of Morgan Stanley Dean Witter's East Coast technology group in investment banking. "But the newer telecommunications companies are struggling." Their inability to raise the capital they need for growth not only affects their own longevity but it also has an impact on telecom-equipment makers, which have fewer customers to sell to. Once again, analysts recommend a flight to familiar names like Cisco (CSCO ). But even Cisco may have some fat left in its stock price as a result of the many weak telecoms among its clients.

One last word of advice. Because the current stock market is so choppy, you not only have to pick and choose but you should buy gradually. This technique, known as dollar-cost-averaging, means that if you invest a bit at a time on a regular basis, you'll consistently buy closer to the bottom if the market keeps falling. Even if you don't catch the exact bottom, you'll at least approach the tip of the V -- and make yourself plenty of money once the market starts to recover.


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By Margaret Popper in New York
Edited by Douglas Harbrecht