Twelve years after the dotcom bubble burst, stocks of large technology companies are finally boasting two things that savvy investors love: moderate valuations and momentum.
The S&P 500 Information Technology Sector Index is up 16 per cent this year, a sign that investor enthusiasm for the industry is on the rise. Prices, though, remain modest. Tech stocks trade at an average multiple of 15 times estimated earnings, which is on par with the broader S&P 500 multiple but considerably cheaper than the industry has traditionally fetched.
Even Warren Buffett, an investor who has traditionally avoided technology, is jumping into the area with his recent purchase of a 5-per-cent stake in IBM Corp. The endorsement of Mr. Buffett, better known for investing in brand-name consumer stocks such as Coca-Cola and American Express, underlines the transformation of the tech sector from high-growth free-for-all to a repository of reasonably priced value buys.
"There's a lot of value in tech now, which is surprising because it was such a growth and momentum story 12 years ago," says Hugo Lavallée, a portfolio manager at Fidelity Investments Canada. "There are value investors now who will look at tech just like they look at consumer staples. They want a low PE [ratio] a good balance sheet and high returns."
IBM , Microsoft Corp. , Cisco Systems Inc. and Montreal's CGI Group Inc. are just some of the tech companies that boast strong free cash flow yields, low valuations, minimal capital requirements and a policy of returning cash to shareholders, says Mr. Lavallée, who helps manage several Fidelity funds, including the firm's Canadian Opportunities Fund.
To be sure, many investors remain wary of tech, remembering the sky-high valuations of the bubble era. Microsoft's value today is the same as it was in April, 2000. Intel Corp.'s recent gains leave it below the level reached in May of 2002. Cisco trades today for less than it did in November, 2001.
At a time when dividend investing is all the rage, tech stocks are still off the radar for many would-be buyers. "Investors want income and tech companies don't pay big incomes," says Frank Mersch, hedge fund manager and co-founder of Front Street Capital in Toronto. "Tech companies are hoarders. They hoard their cash because of [capital expenditure]and development requirements."
So how should investors play the sector? A few tips from the pros:
Boring is good: Mr. Lavallée has concentrated on buying out-of-favour tech stocks with low valuations. That has included Hewlett-Packard Co. – whose stock was beaten down after a decade of changing leadership, poor execution and insufficient investment – and Cisco , which had a lengthy run of quarterly earnings misses. Both companies have been refocusing their businesses and could see big gains ahead, he said.
"I don't try to predict the next trend. I'll focus on the boring tech companies that generate so much cash that I can feel pretty good about getting a good return," Mr. Lavallée says.
Software means stability: Conservative investors should favour software companies over hardware makers, because software firms consume less capital. The most successful software makers, such as Oracle Corp. and SAP , can generate billions in recurring revenue every year, through service and maintenance agreements.
Hardware players are riskier, in due to their ravenous need for capital. Intel , for example, must spend about $3-billion (U.S.) to build a manufacturing plant. Production itself is full of risks, from component delays and design flaws.
Mind you, a hardware company that hits it big can spew profits. Case in point: Apple Inc. , which has turned the iPad and iPhone into rivers of cash.
Get mobile: One trend to watch – and perhaps ride – is the move to fourth-generation wireless technology, known as LTE (long-term evolution).
Qualcomm Inc. , the world's largest maker of chips for mobile phones, is one firm that will benefit, says Rob Enderle, a long-time technology analyst in Silicon Valley. The California-based company recently boosted its forecast for the year, raised its dividend and said it would spend as much as $4-billion to buy back shares.
Another company making some big gambles that could pay off handsomely is Samsung Electronics Co. Ltd. Already the world's No. 2 handset maker, the South Korean company is aiming to double sales of smartphones and tablets this year. It is also investing heavily in the next-generation of high-performance TVs and displays, which Mr. Enderle interprets as an early effort to corner the market.
"There is a lot of inherent risk in tech," Mr. Enderle says "For investors a lot comes down to how risk averse they are. But the tech market still has a substantial amount of head room in it."