The Tech Rally's Next Stars?

Many strong stocks, especially in software and services, have been overlooked, and now may be the time to latch on to them

By Olga Kharif

For a little while recently, the bears had a reason to gloat -- especially where tech stocks were concerned. In the last week of September's sell-off, the Nasdaq fell 6%, to 1,786, and the bears responded with a triumphant "I told you so: Tech stocks are overvalued!" They were convinced the past year's tech rally has been nothing short of a miracle, with the Nasdaq rising 57% since October, 2002, when the market bottomed. Naturally, such a run-up has sparked concerns that tech valuations are inflated -- again.

As a result, many mutual funds recently trimmed their positions. The $113 million AIC Diversified Science & Technology fund sold shares of networking giant Cisco (CSCO ) in the past month, figuring that at a price-to-2004-earnings ratio of 31, the stock has peaked. Likewise, U.S. Global Investors All-American (GBTFX ) fund recently sold some of its stake in the world's No. 1 computer maker, Dell (DELL ).

Most fund managers still believe tech's biggest stars, like Dell, Cisco, and the world's biggest chipmaker, Intel (INTC ), will continue to gain over the long term. But many are starting to look for other, less pricey tech stocks that offer greater potential for gains. That's partly the reason for the recent Nasdaq pullback.


  Turns out the fund managers may be on to something: Plenty of relative bargains are still available -- particularly in the software and services sectors, this recovery's late bloomers. Although corporate information-technology spending has risen from $385 billion in 2001 -- a truly bad year -- to $425 billion in 2003, the increase heavily favored computer hardware, explains James Glen, a senior economist with consultancy That's why hardware and related stocks, such as semiconductors, have rallied so much: Intel shares have risen 82%, to $28.19, so far in 2003.

Shares of software and IT-services providers haven't been as fortunate. These outfits' revenues, adding up to 45% of IT spending, climbed 5% in the second quarter of 2003 vs. 13% for hardware companies, Glen estimates. And spooked by complex software implementations in the late '90s that ran way overschedule and -budget, many customers continue to delay needed purchases.

However, as the recovery gains momentum, they "can't stay away forever," says Vincent Colicchio, a portfolio manager at the $20 million U.S. Global Investors All-American Equity fund. And regardless of the rebound's strength, many businesses need software to comply with new regulations, such as the Sarbanes-Oxley Act mandating greater transparency in corporate financial reporting.


  For investors, it's not too early to jump into this sector even though corporate-software spending will increase just 1.75% this year, to $63.9 billion, estimates Albert Pang, an analyst with tech consultancy IDC. Spending on services will also rise. Colicchio expects to see an uptick in the sector's revenues in two or three quarters. Over the long haul, the $536 billion worldwide IT services industry will grow to $707 billion by 2007, according to market consultancy Gartner Dataquest.

Investors with some appetite for risk can find bargains in the software sector, points out Sameer Bhasin, equity analyst with OKUMUS Capital, a $500 million New York-based hedge fund specializing in value investments. For instance, he figures the fair value of data-processing software maker Compuware (CPWR ) stands at $18 -- vs. its current $5.52. Strategy execution problems have plagued Compuware, but it's getting its act together, he says, after revenues fell 12%, to $306 million, and income fell by 88%, to $2.6 million, in the first half.

The tech-services sector's average p-e hovers around 14.5, while tech as a whole is trading at 15 to 27, estimates Colicchio. He recommends and holds IT outsourcer Affiliated Computer Services (ACS ), now $47.40 a share. In the past few weeks, he bought shares of IT consultancy Accenture (ACN ), which is trading at $22.10 a share. Colicchio also likes but doesn't hold IT powerhouses Electronic Data Systems (EDS ), IBM (IBM ), and Unisys (UIS ).


  Another stock that's probably cheaper than merited, some analysts say, is PeopleSoft (PSFT ), which makes software packages that can be used to manage all transactions within an organization. PeopleSoft's shares fell in June when rival Oracle (ORCL ) made a bid to acquire it. Oracle thinks the company is worth at least $19.50 a share -- its latest bid -- while PeopleSoft's stock is trading at $18.95.

InterActive Corp. (IACI ) could prove to be a bargain as well. It fell by 17%, to $33.23, in the past two months after an acquisitions binge. On Aug. 8, it completed its purchase of the leading online lending and real estate exchange LendingTree and online travel leader Expedia. And on Sept. 22, it bought, a discount travel site (see BW Cover Story, 10/13/03, "The Web Mogul").

Investors are worried about integration. But they should look at the big picture instead, says Michael Sandifer, investment committee member for the Amerindo Investment Advisors funds, which hold the stock. InterActive's revenues should grow at 40% a year, since sites like Expedia are likely to expand their market share, he says. InterActive's stock price is likely to follow.


  Of course, the sector's progress could be impeded if the recovery weakens for any reason, says Donald Luskin, chief investment officer at economic and investment consultancy TrendMacrolytics. He cautions that the outlook isn't as certain as he would like. And being selective is crucial. Valuations for many stocks are too high, says Peter Hofstra, senior investment analyst at the AIC Diversified Science & Technology fund.

Still, for now, investors can find promising tech shares in software and services that are cheaper than they should be.

Kharif writes about technology for BusinessWeek Online in Portland, Ore.

Edited by Beth Belton

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