By Timothy J. Mullaney When Cisco Systems (CSCO) signaled cautious guidance for the rest of 2003 in its otherwise respectable May 6 earnings report, yellow lights flashed across the tech sector: Stocks like IBM (IBM), Oracle (ORCL), and Microsoft (MSFT) all suffered sell-offs on the news.
Such is Cisco's reputation as a tech bellwether. Yet, the Nasdaq composite average is up 3.3% since May 8. And that anomaly raises an interesting question as the tech industry mounts a long, tortuous march back toward prosperity: Which tech stocks are the best bellwethers these days, and how will investors know when the tech bust is easing for real?
Not that Cisco isn't a stock to watch closely. But you have to keep an eye on more than one in today's market, perhaps as many as five or six. Pros break the new tech bellwethers into two groups. A handful of companies, such as IBM and Microsoft, are involved in so many different parts of the industry that, by themselves, they're reasonably strong indicators of what's happening right now.
LUKEWARM GAINS. The other group is mostly related to semiconductors, which are the tech sector's mine canaries. If business is good at companies like Intel (INTC), chipmaker Taiwan Semiconductor (TSM), and semiconductor equipment leader Applied Materials (AMAT), that's a sign that chips orders are strong, which means computers are getting built and that software and services won't be too far behind. In that sense, chipmakers are a narrower indicator than broadline companies such as IBM, but more forward-looking.
Still, the performance of big tech companies says a lot more than small ones about the industry's condition. "You can almost do it just by looking at market caps," says Michael Sola, manager of the T. Rowe Price Science & Technology Fund. Right now, the tech bellwethers are signaling lukewarm gains. Intel has forecast that second-quarter sales will be about flat, compared to the first quarter. IBM Chairman Samuel Palmisano recently predicted 5% to 7% annual sales growth over the next few years, and Merrill Lynch tech strategist Zhen-Hong Fan says Big Blue will probably grow closer to the lower number.
The most bullish comments have come from Taiwan Semiconductor, which reported an 11% sales gain for the first four months of 2003 and says it expects "a firm trend of growth and improved profitability in the current quarter." But Applied Materials was much less upbeat when it reported earnings on May 13, with CFO Joseph Bronson telling a conference call of analysts that "the semiconductor industry continues to plod along."
"BORING LOOKS PRETTY GOOD." That view is backed up by last week's economic data. A May 16 report says April orders for semiconductor equipment fell 5% from March, indicating that most chipmakers are still cautious about spending, and industrial production fell sharply for the second straight month. Plus, demand continues to be weak from financial-services firms, which are huge consumers of computers and software. "I thought first-quarter earnings would be pretty boring, and that's what we got," says Pip Coburn, tech strategist at UBS Warburg in New York. "But if your expectation is disaster, boring looks pretty good."
Nonetheless, Wall Street has been bidding up chips and other tech stocks to a point where many analysts think some shares may be overvalued. On May 5, Merrill Lynch analyst Joseph Osha predicted that the Philadelphia Semiconductor Index, which has risen almost 25% since March, would give up its gains within three months. Eleven of 19 analysts following IBM rate the stock a hold. Dell Computer (DELL) and Cisco both sport modest ratings of 2.3 on Wall Street's consensus scale, where 1 is strong buy and 5 is strong sell.
Here's the hard part, however. The stocks that tell you when an upturn is coming may not be the best investments once things get moving. One result of the bust has been a concentration of market capalization in a handful of tech names prized more for their stability than their growth prospects.
LOWER-RISK BETS. These stocks may be highly valued now, but they'll likely have less upside as a strong recovery takes hold. Even though sales at big names and recent favorites such as Dell, Cisco, Microsoft, Oracle, and IBM tell you what's happening in the industry, these companies have little operating leverage. That means they won't be as able to turn small sales gains into much larger profit increases, says Wit Soundview strategist Arnie Berman.
Berman's theory is that the top players are for cautious investors who want to make a lower-risk bet on a tech rebound. "If tech goes up, they participate. But if tech goes back down, they don't get killed," he reasons. He thinks bigger gains can be had in second-tier players like Foundry Networks (FDRY) and Extreme Networks (EXTR).
Even an improving economy may not provide much salve for companies on the wrong side of the tech biz's fundamental changes. Take Sun Microsystems (SUNW), which is struggling to cope with the rising popularity of open-standards software, especially the Linux operating system. Then there's Dell, which is rapidly stealing market share from its rivals. Its 31% first-quarter profit gain, announced last week is more likely a sign of trouble -- not recovery -- for rivals like Gateway (GTW) and Hewlett-Packard (HPQ). "Some big stocks tell you more than others," Coburn says. "And they all have their own specific risks."
The last three years have been rough on tech investors. This year's climate is probably less dangerous than it has been. Yes, Cisco is one tech stock to watch for clues. But savvy investors will broaden their tech barometers if they want a more accurate forecast of what to expect from the tech industry. Mullaney is E-Business editor for BusinessWeek in New York