Online Extra: Making a Case For Tech Stocks

S&P's Scott Kessler says despite the usual risks, lots of technology companies have solid fundamentals and good valuations
The BusinessWeek 50

Since the technology bubble burst in 2000, the sector has outperformed during only one of the past five years. However, even in the absence of any eyebrow-raising killer applications or blockbuster advancements, Standard & Poor's head of technology equity research, Scott Kessler, still sees plenty of solid tech companies with attractive valuations and solid fundamentals.

Of course, risks come along with investing in the sector, which is currently looking overvalued. In addition, changes in the way businesses account for stock-option expensing could cause problems for many tech companies. But Kessler argues that some bright spots remain. He spoke with BusinessWeek Online's June Kim on March 17 about the argument for and the risks involved with staying in technology. Edited excerpts of their conversation follow.

Note: Scott Kessler is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this article. All of the views expressed in this article accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to and click on "Investment Research" and then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts."

Q: How's the tech sector doing so far this year?


Through Mar. 11 year-to-date, it fell 5.7% compared with a decline of 0.8% for the S&P 1500, a broader swath of companies composed of the S&P 500, S&P Mid-Cap 400, and the S&P Small-Cap 600.

Q: What's the outlook for the coming year?


Our outlook remains marketweight. Essentially, as of Friday, Mar. 11, technology stocks accounted for roughly 15.25% of the S&P 500. We're recommending a comparable weighting.

Q: What are the arguments for staying in technology stocks?


There are probably three good arguments for folks to be involved in technology stocks. The most obvious is that the fundamentals for a lot of these companies are solid. They had good fourth quarters, and the economy is relatively healthy in the U.S. and around the world.

Secondly, it's our opinion that these companies are as attractively priced as they have been in some time. We expect operating earnings per share to increase 19% for large-cap tech companies in 2005, and the average [price-earnings ratio] of the sector is 21. That's above the S&P 500 p-e of 16, so people might say technology p-e is expensive.

But the more sophisticated investors will see what kind of growth they'll be getting in operating earnings. You're essentially paying for the growth, but paying for it in a way that is a nice value relative to what tech historically has traded at.

Thirdly, tech companies have very strong balance sheets with more cash, little debt, and margins that tend to be higher than other sectors. Companies tend to hoard their cash because they're not sure where the next opportunity will present itself for an investment or an acquisition. Now, they're actually starting to put that cash to good use. You have companies that are repurchasing stock, companies are initiating and boosting their dividends, like Germany's SAP (SAP ) which recently indicated a substantial increase.

You've also started to see hints of some pretty significant M&A. Just in the last year, we've seen Oracle (ORCL ) close on the acquisition of PeopleSoft, and Symantec (SYMC ) announcing the purchase of Veritas (VRTS ).

Q: What are the risks in tech investing?


The first quarter tends to be seasonally weaker, so in the near term, there could be some trepidation about whether seasonal weakness will be more pronounced.

The second issue is options expensing. Tech companies by far have used options more aggressively than companies in other sectors for compensation. They will probably have to start including options expenses on their income statement due to accounting rule changes made by FASB [Financial Accounting Standards Board]. It's going to hit company profitability, as well as operating and net margins.

A third, more far-reaching risk is whether tech sector growth should be in excess of GDP growth. Some believe there's only so much more that can be squeezed in on a productivity standpoint, and investment in technology in terms of the boom that happened in the mid- to late-1990s isn't going to be replicated or be close to what it was going forward. There really isn't any kind of killer application or primary motivator for significant increase in spending.

Q: What subindustries do you think will perform well this year?


We're positive on the Internet software and services subindustry, mostly reflecting the performance of Yahoo! (YHOO ). We have a buy recommendation on Yahoo, Google (GOOG ), and a strong buy on ValueClick (VCLK ).

People spend 15% of their time with online media, yet from an advertising perspective, corporate budgets are only committing 3% to the Internet. History shows the amount committed to certain medium tends to increase to the usership number. I think that 3% number will increase substantially in the next couple of years.

Advertising on the Internet is not only less expensive, but it can be a lot more targeted and a lot more interactive than any other media out there.

We're also positive on software companies like Microsoft (MSFT ) and Internet security companies. We have a strong buy on Microsoft because of its strong core franchises and new growth areas, like video games and Internet services, that are very lucrative. They also have a strong balance sheet and nice dividend payouts –- a nice total return story at this point.

Q: Are there any other areas or companies that you like?


We also have a strong buy on McAfee (MFE ) and RSA Security (RSAS ), and a buy recommendation on Check Point Software Technologies (CHKP ). Internet security companies are great long-term plays on what is an increasing priority of both corporations and consumers to protect themselves from the reality of hackers and personal-identity theft.

Edited by Patricia O'Connell

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