Tug of War over Tech Stocks: Are They Heading Up, or Down?

These days, investors don’t have to search far for reasons to jump on the technology bandwagon. The hit that Google’s IPO scored is looking like a homerun; stock valuations are relatively cheap compared to previous multiples; companies like Apple Computer are reporting strong earnings on sales of the innovative iPod, and the sector is entering a seasonally strong fourth quarter. Investors also seem to be betting that the worst news is over for key industries such as semiconductors. Chip companies have been hit by weaker than expected earnings from Intel and smaller peers, but shares of Semiconductor Holders, an electronic traded fund (ETF), are up more than 15% from a Sept. 7 low of $27.99.

“I’m not in favor of overweighting technology stocks but clearly these prices have come down,” says Wharton finance professor Jeremy Siegel. “Yes, Google is marching up, but it’s not like Yahoo in 2000.” Siegel says he’s “still not positive” on technology companies’ ability to deliver a steady stream of increasing profits, but does note that software spending is in a slight up-trend. The jury is still out on whether it’s too early to be wildly bullish about technology.

According to Wharton finance professor Andrew Metrick, there are no signs indicating that technology will see a renaissance like five years ago, which was clearly an investment bubble. “I just don’t see it,” says Metrick, adding that he expects the stock market to trade “sideways,” up and down with little direction either way. “I think people are too battle-scarred to become too exuberant.”

Of course, that directionless trading means that you are likely to see a tug of war over technology stocks. Here’s the case for and against these high-fliers.

Tech Spending On the Rise

Despite the collective skepticism about technology stocks from Siegel and Metrick, there is evidence that the sector has plenty of sex appeal. Such momentum can be contagious as investors continue to look for the next big hit. Consider the evidence:

• Google’s third quarter performance ending Sept. 30 was stellar. On Oct. 21, the company reported earnings of $52 million, or 19 cents a share, on revenues of $805.9 million, up 105% from a year ago. “Dedication to our users, combined with our relentless technology innovation and market opportunity, make us very optimistic about our company’s future,” said Google CEO Eric Schmidt. The reaction: A $40 gain in eight days. Now Google shares are near the $200 price target set by Prudential Securities. “An investment in Google is, in effect, an ownership stake in a company with maximum exposure to the online advertising market’s fastest-growing format,” said Prudential analyst Mark Rowen in a research note.

• So what do you do when you missed the Google run? Try to find the next big thing. Shopping.com, an online comparison shopping company that tried to go public at the dot-com bust but had to cancel its offering, hit the market at $18 on Oct. 26 and quickly posted a 52% gain. The big question is whether these high-flyers are long-term investments. The consensus is that Google is a keeper, according to Jeffries analyst Youssef Squali. But investors hunting for the next Google may be disappointed. Ask Jeeves, another search company, reported weaker than expected financial results and saw its shares lose more than 20% Oct. 28.

• Telecommunications giant Verizon and cable rival Comcast both intend to increase capital spending. That means the companies that sell equipment to these competitors, such as Lucent Technologies and Cisco Systems, will benefit.

• According to research firm Gartner, spending on information technology is expected to rise 5% in 2005. Although that level is low compared to the boom times, it’s on the right track after three years of stagnant growth or actual declines.

In addition, an increase in spending could theoretically lead to better results for the bulk of technology companies, which cater to businesses instead of consumers. In a research note, Merrill Lynch analyst Steven Milunovich recommended that investors start moving money from technology companies focused on consumers to firms selling to corporations.

According to Merrill Lynch, consumer technology stocks like Apple have outperformed companies tethered to corporate spending by 36%, but this could change. Milunovich argues that strong results from IBM and EMC show that there is “some life” in enterprise spending. “We have suggested tech investors be prepared to move money from consumer to enterprise-driven names,” he said. “That time may finally be here.”

Little Exuberance

Milunovich’s argument resembles previous cases where an analyst expected corporate spending to take the baton from consumers and keep the economy growing. Unfortunately, corporate executives have been skittish as they hoard cash and hold back technology purchases.

The problem with linking technology stock performance to the broader economy is that often there is little correlation. Technology spending, the real economy (including, for example, gross domestic product, retail sales and industrial manufacturing) “and the stock market are things that often aren’t closely related,” says Metrick. Technology spending is back a little bit, but without exuberance. There doesn’t seem to be a big push, he suggests.

Add it up and some optimistic forecasts for information technology spending may simply be wrong. According to a Merrill Lynch survey of 75 U.S. chief information officers and 25 European counterparts, 2005 technology spending may be a slight 2%. The report states that most companies view IT as important, but want to keep a lid on spending. Couple Merrill’s survey with Gartner’s and it’s unclear how spending will pan out.

In addition, the giants of technology are lagging. Wall Street analysts say the heady growth days are gone at Microsoft, especially while it waits to unveil its latest operating system. For example, Credit Suisse First Boston analyst Gibboney Huske says he remains neutral on Microsoft shares for three reasons: slowing PC sales growth; limited product pipeline before the release of Longhorn, Microsoft’s latest operating system; and the absence of another big dividend payout to attract investor attention.

Intel has also struggled in fending off rival Advanced Micro Devices. Intel reported profits of $1.9 billion on revenues of $8.5 billion for its third quarter, but officials said the company had to work off an inventory glut. “Growth was not as high as we originally anticipated due to inventory adjustments at some of our major customers and lower than expected overall demand for PCs,” said Intel CEO Craig R. Barrett in an earnings release.

Can the technology sector thrive when two of its pillars are limping?

Other Investment Avenues

No matter where you fall on the technology bandwagon, it’s safe to say that you will be paying more for technology stocks relative to other shares in arguably more profitable sectors such as energy and health care. “Technology stocks have always been and almost always are overvalued,” says Siegel. “But the public will overpay for them.” He adds that investors may garner better returns by looking at energy companies (which are benefiting from high oil prices), consumer staples firms and pharmaceutical makers.

Pharmaceuticals may be the best place to look for value, according to Siegel, although the sector has been rattled by a few issues. Merck, for example, had to recall its arthritis drug Vioxx because it was linked to heart attacks. Now the company has been hit with a bevy of lawsuits. Meanwhile, Pfizer faces concerns about generic competition. And there’s the risk that its arthritis drug Celebrex will ultimately be targeted by regulators and lawyers.

Yet there are positive signs and evidence that pharmaceutical shares are cheap. The financials are also strong: Wyeth reported better-than-expected third quarter earnings of $1.4 billion on sales of $4.5 billion. Pfizer reported third quarter earnings of $3.34 billion on revenues of $12.8 billion and indicated that it held its own amid pricing pressure from rivals.