Down, not out: Tech stocks still attract bargain hunters

by Cynthia Harrington

Eyebrows arched when Warren Buffett, Bill Miller and Longleaf Partners invested in perennial money loser Level 3 Communications last year. Market watchers wondered what these three staid and stodgy investors sought in that tarnished telecommunications company.

The answer emerged over this year as the Wall Street bloodbath continued. With technology and communications funds occupying the basement for year-to-date and three-year returns, their stock prices represent good value to some investors.

"Value players are moving into these beaten down sectors," said Christopher Traulsen, senior analyst at Morningstar Inc. in Chicago. "They’re focusing on companies that are cash rich, so even though business prospects near term could only be called atrocious, buyers believe there’s enough cash to ride out the downturn."

Morningstar’s fund rankings reflect the paucity of expectations for domestic technology and communications funds. The two sectors bring up the rear with year-to-date performance of -35 percent and -36 percent, respectively. This year is bad, but it’s probably the length of the downturn that causes the most depression. Tech and communications have fallen by 30 percent and 29 percent over the last three years.

But tech’s newfound audience isn’t universal. "I’m not seeing they’re irresistible," said Melanie Hummer, CFA, CFP, CPA, of Chicago-based Hummer Financial Advisory. "A decent dividend is 2 percent, and they’re not even near that. Plus these stocks still have high P/Es, which assume a continued very high growth rate."

Hummer customizes each client’s portfolio, following broad asset allocation models. She then buys stocks directly within each class. "While I bought and still own the tech leaders like Intel, Microsoft and Cisco, I’d never buy more than 5 percent in this sector for any client," said Hummer. "Even my high school age children’s portfolios have none. With less than five years until I need to draw on those funds for college, they can’t take the volatility."

Followers of modern portfolio theory might also find themselves committing more client funds to technology. Strict indexer James A. Shambo, CPA/PFS, of Lifetime Planning Concepts, in Colorado Springs, Colo., expects the change when he rebalances this year. "With what’s happened this year, I’ll end up buying more," said Shambo. "But with the technology sector I don’t have to pay too much attention. The index adjusts for that sector naturally as the value of tech falls. So does the allocation in the index."

The sector weightings of the S&P 500 normalized over the last couple of years. At the top of the recent heyday, technology represented 23 percent of the broad index, and telecommunications another 8.25 percent. The growth subset was even more skewed, with 34 percent tech and 11 percent telecommunications. By October this year, technology had fallen to 16 percent of the broad index and 22 percent of the growth subset. Telecom represents only 4 percent of the broad index and a measly .35 percent of growth.

The natural rebalancing in the index supports the mechanical rebalancing by adherents to passive investing. Shambo pointed out an exception, which is health care. Because most health care companies are large cap, when he adds small and mid-cap funds to a portfolio, the weighting to the health care sector is diluted.

He adds the actively managed Vanguard Health Care Fund to shore up that segment of the economy. "Technology companies spread evenly over the size categories, so I don’t need to pay too much attention to that sector," said Shambo.

Indexers will also find themselves owning more technology in the value asset classes. "The changes in the tech sector show mostly in the shift of companies from the growth classes to value," said Traulsen, who specializes in the analysis of technology mutual funds for Morningstar. "One of the few new tech funds over the past year comes from a value house, the Royce Funds."

Approaching its first anniversary, the Royce Technology Value Fund launched Dec. 31, 2001. "This is unusual because mostly tech funds are closing," Traulsen said. "At the peak there were 45 funds in the Internet subsector and now there are 13. That ratio is similar in the tech sector as a whole."

The biggest shift is in telecommunications. Not only have revenues dropped for telecommunications providers, but accounting scandals at players like Global Crossing and WorldCom burdened market prices of the entire sector. With business down at the provider level, orders for telecommunications gear dried up.

Yet value players like Bill Miller at Legg Mason Value Trust and Martin J. Whitman with Third Avenue Value have positions in the gear makers. Showing up in these portfolios are names like Tellabs Inc., down from a high of $18, to $9.50, and Ciena Corp., down from $21, to $5. Comverse Technology is currently at $11, down from a high of $28.

"Other technology sectors are not as active," said Traulsen. "Some value investors try to catch the cyclical bottoms of the semiconductors but so far this year we’ve seen two bottoms in that group."

Few professional investors are optimistic about the near future for the return to growth in the sector. There isn’t much hope for recovery in general until corporate profitability increases. Only then will spending on IT come back.

According to Traulsen the only possible exception is in PC upgrades. Companies upgrade to new boxes when it’s cheaper to buy new than to maintain the old. Buying pressure builds as this cycle grows longer in the tooth.

What’s more distinctive is the lack of consensus about specific prospects for recovery. One investor, for instance, believes that the enterprise software companies will soar with a small uptick in business because the product profit margins are so generous.

"But I talk to the next portfolio manager and I hear that too few customers realized their expected return on investment from the enterprise products bought in the 1990s, so a return to the old demand for the product is unlikely," says Traulsen.

Hummer underlined another potential opportunity in the technology sector. She’s watching the new Congress in anticipation of a change in the tax code that could make fast-growing companies more attractive to investors.

"Ultimately, the value of an investment is the present value of future cash streams," she said. "The higher the dividend the greater the certainty of the amount of return. Our current double taxation of dividends just encourages volatility in the markets."

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