Go for Tech's Tried and True

There are good reasons for NASDAQ's recent surge. But niche players aren't one of them.

IBM (IBM ) and Microsoft Corp. (MSFT ) trotted out surprisingly strong third-quarter earnings, and investors jumped at the chance to rekindle an old flame, tech stocks. Since its 2002 low on Oct. 9, the tech-laden NASDAQ index is up 22%.

That's not purely a case of hope triumphing over reality. After cutting tech spending for five years, businesses need to start buying again. Be careful, though. With stocks--as with old flames--nostalgia is the mother of disillusion. The bubble babies now trading at $1 a share are no bargain. But some tech titans, lean and recession-toughened, are buys. "You have to own the dominant companies--the Ciscos, the Microsofts--because they're going to be the ones that gain market share in this environment," says Steve Galbraith, Morgan Stanley's chief U.S. equity strategist.

That's happening now in software. Companies are putting their tech dollars only into essential programs, delaying purchases from niche companies. That's why Arnie Berman, tech strategist for SoundView Financial Group Inc., an investment boutique based in Old Greenwich, Conn., believes German giant SAP's (SAP ) revenues will boom. Once companies install SAP programs, which let them monitor production, they rarely switch, he says. Many are overdue for an upgrade. "I've talked to lots of manufacturers who have postponed upgrades of SAP for so long that they're now running versions that SAP doesn't support," says Berman. At $20, the stock has doubled since early October, but it's still worth just a quarter of its March, 2000, peak. Assuming a recovery, Berman thinks the stock will likely hit the low 30s in the next 12 months.

Market dominance and price are big reasons to buy Microsoft now that it has settled antitrust allegations with the government. Value investor Henry J. Herrmann, chief investment officer at Waddell & Reed Financial Inc., a $29 billion fund family, rarely buys tech. But Microsoft is now his fourth-largest holding. Why? It trades at the same price as it did in May, 1998, when the government filed its suit. Analysts see a surge in revenues as companies upgrade PC operating systems from Microsoft's Windows 98 to Windows XP, which is expected to require less maintenance. Also, Microsoft can now branch into areas such as online services, where it once felt constrained by the suit. The big hope: With $40 billion in cash, Microsoft--which pays no dividend--may pay one if Congress eliminates double taxation of dividends. "Microsoft could easily afford to pay out 30% of its earnings in dividends," Herrmann says.

Money managers believe that Cisco Systems Inc. (CSCO ), like Microsoft, will expand at its rivals' expense. It has a strong product mix and $21 billion in cash. Despite the drop in demand for its computer networking products--which slashed its stock price by 83%--Cisco generates $1 billion in cash each quarter and has gross margins of 69%. UBS Warburg tech strategist Pip Coburn believes that Cisco can offset weak networking with storage, security, and telecom software. "Cisco has a real chance to gain meaningful and profitable share in telecom," he says.

Security software also falls under the rubric of essential spending, given concerns about hackers and terrorists. That's why Alan Weinfeld, an analyst with Fulcrum Global Partners LLC, a New York research firm, likes Santa Clara (Calif.)-based Network Associates Inc. (NET ), maker of the well-known McAfee antivirus software and a turnaround play. Now around $15, the stock fell below $2 in early 2001. The new CEO, IBM veteran George Samenuk, has focused on markets where the company is a leader, landing antivirus software contracts with Dell Computer (DELL ), AOL Time Warner (AOL ), and Sony (SNE ). A new product that heads off network crashes is also a hit. Weinfeld believes that Network Associates could earn at least 75 cents a share in 2003, vs. 66 cents for 2002--giving it a price-earnings ratio of 21. "We're confident in management, confident in the products, and the valuation is attractive," he says.

Most analysts are wary of semiconductor companies because wireless-phone makers, which are big buyers, are in the dumps. But Berman, the Soundview strategist, sees value in Taiwan Semiconductor Manufacturing Co. (TSM ), a leading contract foundry. TSMC's stock collapsed last summer when orders from a key customer, Nvidia Corp. (NVDA ), plunged. But it quickly replaced that business. November revenues were up 32% year-on-year, thanks to outsourcing from other chipmakers. With its "leading-edge production capabilities and lower-cost structure," TSMC has the edge on rivals, Berman says.

The key thing for investors to remember, as those tender feelings creep back: Don't get swept off your feet. There's overcapacity in telecom equipment, network servers, and business software. Many companies are still pricey, assuming earnings growth of 5% or less. Merrill Lynch & Co.'s Tech 100 index is trading at 35 times projected 2003 earnings--half of its peak but still twice the average p-e in 1996. Apply Mom's advice on love. Go for the good providers. And stick with them.

By Dean Foust

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