Skirting the Tech Minefield

Even with prices low, the outlook is treacherous

So what's a battered technology investor to do in the second half of 2001? The pros are trying to stay out of the line of fire. Manager Kevin Landis, whose Firsthand Technology Value fund is down 38% this year, is worried that more problems lie ahead. Therefore, 13% of his fund is in cash, and the rest in "the safest stocks" he can find. His top sector is software, with picks such as corporate systems suppliers Siebel (SEBL ) and BEA Systems (BEAS ), which are down this year--though they are among the few tech companies with healthy profits.

Some optimists hope the tech-heavy Nasdaq index will end the year flat. But that will require a gain of nearly 22%, which most die-hard tech investors aren't expecting. "I'm just not that enthusiastic while people keep blithely paying high prices for tech," says Peter Doyle, chief investment strategist at Kinetics Assets Management, which manages six technology funds.

The bulls' case is based on the idea that stocks have been pummeled badly already and that they will improve in 2002. But many pros aren't optimistic that the Fed's five interest-rate cuts will stimulate the economy quickly enough to help tech stocks anytime soon. Indeed, they worry profits will slow sharply in the second half. Wall Street analysts expect that third-quarter profits of tech companies in the Standard & Poor's 500-stock index will fall 43%, followed by a 17% drop in the fourth quarter, according to First Call. Only in 2002 are profits expected to soar, with a 50% rebound.

The smart money is skeptical of such a jump. More blood will be spilled from bankruptcies and slower growth, with telecom still badly hit. James Floyd, tech strategist for Leuthold Group, a Minneapolis investment firm, thinks there will be "significant rallies over the next few months, but the rallies will give way" as investors take profits and reshuffle portfolios.

A TOUCH OF BRIGHTNESS. The bottom line is that tech stocks are still not cheap. After hitting a low of 29 times estimated 2001 earnings in April, the 300 tech stocks tracked by Leuthold bounced back to a price-earnings ratio of 36 at mid-June--well below last year's peak of 115 but above their long-term median of 33.

Growth is slowing across a broad swath of tech, and there are worries that many of yesterday's leaders will struggle. At $16.65, Cisco Systems (CSCO ) trades at 39 times estimated 2002 earnings, which the Street expects to jump 153%. Likewise JDS Uniphase (JDSU ), at $12.44, trades at 25 times estimated 2002 profits, which are forecast to be up 63%. "There will be an unwinding of valuations in big tech names" in the second half, says Doyle.

Many tech pros are eyeing small and midsize stocks that have fairly strong revenue prospects. Peter Trapp, manager of Needham Growth Fund, likes software and data storage companies that he expects to weather the storm well. Among his favorites are Bell Microproducts (BELM ) and Legato Systems (LGTO ). Legato, which makes data-storage software, has tumbled from $80 in July, 1999, to $6.50, but Trapp says new management should turn the company around. Bell Microproducts, a data-storage supplier, is selling at 40 times estimated 2001 profits.

Doyle, whose Kinetics Internet fund is one of the top tech funds this year--down just 1.2%-- has moved out of dot-coms and is "going after asset plays and companies that will become stronger as the shakeout continues," he says. His top stocks include Liberty Media Group (LMG.A ) and Gemstar-TV Guide (GMST ), which he thinks will become major content providers for the Net. He also owns companies selling below the value of their assets, such as multimedia holding company Lynch Interactive (LIC ), which he hopes will be broken up by chairman Mario Gabelli.

John Seabern, co-manager of RS Investments' Diversified Growth Fund, down 24% so far this year, has been buying small companies with fast-growing sales--even if they don't have profits yet. One of his picks is e-learning company, whose revenues jumped from $1.9 million to $8.6 million in the first quarter.

Many tech investors are watching for dips that send stocks they like near new lows. Even if that happens, they won't be buying as frantically as they did in the good old days of 1999.

Corrections and Clarifications "Skirting the tech minefield" (Cover Story, July 2) reported an incorrect year-to-date return for RS Investments' Diversified Growth Fund. The fund's return through June 15 was -3.5%.

By Geoffrey Smith

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