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Making the case for technology

A decade after the Internet bubble burst, many investors remain guarded about technology stocks

A decade after the Internet bubble burst, many investors remain guarded about technology stocks. However, technology isn’t a single, homogenous market, and if segmented properly, a broad spectrum of equity ideas emerge — from high-growth, fast-paced, pricey businesses to mature companies with understandable risks and reasonable valuations.

To divide the tech universe, start by looking at the end markets. Where technology “creates” new markets, such as tablets and smart phones, one will find rapid growth, richer valuations and higher risk.

This rapid growth is funded by people or organizations buying “new” technologies, which they sometimes never knew they “needed” (think iPads) and by the outright replacement of older products. In this fast-growth segment, valuations are rich, execution is paramount and “beat-and-raise” quarters are mandatory.

However, at the opposite end of the spectrum are the lower-multiple, slower-growth, more established businesses (e.g., IBM and Microsoft Corp.). Although technology is still widely considered a “new” market, investors should note that IBM shipped its first mainframe computer, and the Internet’s foundations were laid by the U.S. government, more than five decades ago.

The second segmentation is made between consumer-oriented technologies such as computer gaming or digital video recorders and infrastructure technologies, such as networking gear and enterprise software.

Investors may face less risk in corporate tech “staples” than consumer technologies.

With the market segmented, there are three characteristics that make tech stocks attractive in this environment.

Technology is among the most profitable sectors of the U.S. economy. Consider that the five biggest technology names — Microsoft Ticker:(MSFT), Apple Inc. Ticker:(AAPL), Google Inc. Ticker:(GOOG), IBM Ticker:(IBM) and Oracle Corp. Ticker:(ORCL) — generated unweighted average operating margins of about 28% in the third quarter, versus 20% for the S&P 500.

Despite strong margins and compelling cash generation, the average price-earnings ratio of the S&P 500 Info Tech Index is about 13.9, which is just above the S&P 500’s P/E of 13.3. Note that earnings for the S&P 500 Tech Index are expected to grow 22% this year, versus 13% for the broader index, revealing a forward price-earnings-to-growth ratio of just 0.6 for technology, versus 1 for the S&P 500.

Strong cash generation has been the catalyst for extensive mergers-and-acquisitions activity among tech companies. Bloomberg estimates that tech firms in the S&P 500 have spent $134 billion on acquisitions during the past three years.

We expect this trend to continue due to attractive business models, strong cash generation and as a byproduct of certain tech subsectors’ maturing. However, significant cash balances remain overseas and efforts are continuing in Washington to find means for repatriation.

In the meantime, we are witnessing Silicon Valley imperialism, with cash-rich tech firms using overseas deposits to acquire innovative companies in foreign markets. Although it is unclear that a true oligopoly will emerge from this M&A activity, we expect the broader tech market to follow the pharmaceutical model for at least the next decade.

In other words, we expect the tech industry to have several large, entrenched vendors on one end and a broad number of small firms on the other. These small firms will serve as the outsourced research-and-development arm and the true points of innovation for many of the larger companies.

Tech firms are flush with cash and can use their balance sheets to benefit investors. Although this capital has been used extensively for mergers and acquisitions, there also have been massive share repurchases in recent years, and dividends are becoming more prevalent.

Tech firms repurchased more than $210 billion in stock during the past three years, including $60 billion through the third quarter of 2010. With the recent tax cut extensions and the maturing of large-cap tech vendors, dividends are poised to expand.

Note that Hewlett-Packard Co. Ticker:(HPQ), IBM, Microsoft and Oracle already pay dividends and that Cisco Systems Inc. Ticker:(CSCO) is planning to initiate a dividend this year. We think that strong balance sheets and cash flow generation deserve at least as much consideration as earnings, and this means that tech stocks merit serious consideration.

Richard J. Sherman Jr. is a research analyst at Roumell Asset Management LLC and co-manager of the Roumell Opportunistic Value Fund (RAMVX).