By Olga Kharif The Federal Reserve is expected to raise interest rates by a quarter percentage point on June 30, the first increase in nearly four years. And the Street's initial reaction to rising rates is often to dump tech stocks in favor of consumer staples, such as energy, food, and health-care companies. Yet that could be the wrong move to make.
A recent study by Standard & Poor's credit-rating service shows that since the 1970s, technology has been the only sector that actually grew in periods of rising interest rates -- by 2% on average, while the rest of the market fell 5%. "Historically, investors haven't been willing to bail on technology because they feel it will still be needed by companies to maintain their competitiveness," says Sam Stovall, chief investment strategist at S&P in New York.
That logic likely applies even more so today. Many businesses delayed tech investments far longer than usual during the past few years, waiting for the economy to improve, so their information-technology infrastructure is crumbling. Now that sales and profits are on the upswing, so is tech spending. A survey of more than 300 chief information officers conducted in May by CIO magazine shows that IT budgets are expected to grow 7.8%, the second-highest increase in three years.
CATCH-UP TIME? What's more, tech outfits make an attractive investment when rates head up because many of them -- especially the newer ones -- carry little debt and don't pay dividends. As a result, their borrowing expenses won't creep up in tandem with interest rates, explains Greg Gorbatenko, an analyst with Marquis Investment Research in Chicago.
Finally, tech stocks have underperformed the rest of the market in 2004. While the benchmark S&P 500-stock index has risen 2.9% since January, the tech-laden Nasdaq is up less than 1%. "Technology stocks are cheap," says John Derrick, director of research for the $1.45 billion U.S. funds. And as rising rates begin to pressure stock valuations, tech could become even more appealing.
Shares of cash-rich concerns -- such as networking king Cisco Systems (CSCO), which boasts $19 billion in cash and equivalents -- might be particularly attractive. "If a company has cash, it can control its own destiny," says Peter Hofstra, senior investment analyst with AIC funds, which owns Cisco. As rates rise, Cisco might be able to get a higher rate of return by investing its cash, or its venture group could offer more attractive financing terms to hot startups, allowing the giant to gain the cream of the crop as new customers, he says. Analysts polled by financial-service firm Thomson One believe Cisco's shares, currently trading at $24, could reach $29 within 12 months.
GOOD BUYS ABOUND. Hofstra also likes Automatic Data Processing (ADP), which provides payroll services and has to hold a lot of cash temporarily. Its shares add up to about 4% of AIC Diversified Science & Technology fund's holdings. In the three months ended Mar. 31, ADP made $96.5 million in interest on funds it held for clients. And as interest rates climb, so will that revenue. The stock, currently trading at $43.60, could reach the high $40s, Hofstra believes.
S&P's historical analysis suggests that stocks in computing hardware, electronic instrumentation, and semiconductors have fared better than the rest when rates are on the upswing. And those sectors could have some good buys following recent, seemingly unfounded fears of a cyclical downturn.
Take hardware. Tech consultancy IDC expects the PC market to grow 5%, to $204.2 billion, next year. Charlie Wolf, an analyst with Needham & Co., likes and owns Dell (DELL), which, he believes, still has no rivals because of its low-cost, direct-sales model. Dell's printer sales are ramping up as well. Analysts polled by Thomson One expect the stock to rise from $35 today to $42 within 12 months.
CHIP FAVORITES. With semiconductors, the situation is a bit trickier. According to some estimates, the chip cycle is winding down. But S&P calls for continued growth in 2005. It recommends PC processor king Intel (INTC), which S&P believes will continue to benefit from strong computer-hardware sales. The stock could reach $42 within 12 months, according to S&P, up from $28 today. Another S&P favorite is Xilinx (XLNX), which makes programmable logic chips increasingly popular in consumer electronics. The stock, now trading at $32.5, could reach $47, according to S&P.
Kevin Landis, chief investment officer at Firsthand Funds, recommends SanDisk (SNDK), a maker of flash memory used for storing files on cell phones, digital cameras, personal digital assistants, and other devices. The stock is trading at $22, but analysts expect the price to reach $37.50 within a year, according to Thomson One.
Electronic-instrumentation companies -- those making tools for research, development, and manufacturing in high-tech industries such as biotechnology -- have fared the best in the past. Though S&P has changed this category's makeup, it still contains heavyweights like PerkinElmer (PKI). John Harmon, an analyst with Needham & Co., has a strong buy on this stock, figuring that PerkinElmer's earnings per share will grow 47% this year, to 80 cents, and 23% next year, to $1.05, as it continues to slash costs. His target price of $25 a share is 23% above the current level of $20.40.
WILL HISTORY REPEAT? Zebra Technologies (ZBRA) might be another good buy. It makes devices that print bar-code and RFID (radio-frequency identification) labels, and U.S. funds' Derrick figures that data collection using these technologies will increase. Indeed, the world's largest retailer, Wal-Mart (WMT), is slowly phasing in RFID use in its warehouses and stores. And everyone from the military to the Homeland Security Dept. is developing new applications for the technology.
Whether historical trends hold true is anybody's guess. And with short-term rates expected to rise two percentage points by early 2005, stocks of all stripes could be hurt as investors seek higher returns in fixed income. Still, for those who want to maintain a diversified portfolio, chances are tech could outperform consumer staples. And while that might seem counterintuitive, S&P analysis shows it has paid off in the past. Kharif writes for BusinessWeek Online in Portland, Ore.