Tech Stocks: A Summer of Love

New products—plus buybacks, dividends, and enticing valuations—lure investors into technology names

Technology stocks are enjoying an uncommon summer of love, as investors have been shifting money away from financial companies in light of the subprime and credit market troubles. "This year, tech stocks are outperforming pretty notably," says Scott Kessler, head of the technology group at Standard & Poor's Equity Research. "Actually, tech stocks were outperforming before the housing and credit issues came to the fore."

In the last 13 weeks through Aug. 24, the S&P Information Technology index has been the best performer among the 10 sectors tracked by Standard & Poor's, with a gain of 3.1%, vs. a 2.4% drop in the S&P 500 index. And for the year (through Aug. 24), the tech index has climbed 10.2%, beating the 4.3% rise in the S&P 500.

Though Kessler is relatively optimistic about the sector's healthy fundamentals, he's worried that the mess in the financial sector will harm the overall economy and spending on technology products and services (see BusinessWeek.com, 8/27/07, "Tech Stock Oasis: Can It Last?"). That's why he favors a limited number of large companies with proven track records, such as Intel (INTC), Microsoft (MSFT), Oracle (ORCL), IBM (IBM), and EMC (EMC).

"Many of the names that appear on our strong buy list are names that people knew and loved in the late '90s," Kessler says. "In many ways, it's back to the future."

BusinessWeek's Karyn McCormack spoke with Kessler on Aug. 28 about the sector and his team's favorite stocks. Edited excerpts of their conversation follow.

Is leadership shifting back to technology stocks, now that financial stocks are getting punished for the subprime and credit mess?

Looking back, 2003 was the last full year that tech stocks outperformed. This year, tech stocks are outperforming pretty notably. Actually, tech stocks were outperforming before the housing and credit issues came to the fore.

There are a number of different reasons for this. One reason is solid fundamentals, based on new products and services as well as the fact that companies really look at technology to both grow revenue and restrain costs and expenses.

The most obvious new products are Microsoft's Vista and Office software and Apple's (AAPL) iPhone. The iPhone had a lot of excitement and caused competitors to step up their product development and marketing. And Nintendo's (NTDOY) Wii was a surprise hit beginning in last year's holiday season and continues to do really well.

Plus, we have a lot of confidence in the longer-term growth prospects outside of the U.S. If you look at the 10 sectors that S&P tracks, only one other sector besides tech generates a higher percentage of revenue outside the U.S.: energy. What a lot of people don't appreciate is that the dollar has fallen and that gives tech companies the ability to generate bigger revenue outside the U.S. And many other countries have lower corporate tax rates. So these companies can convert more revenues into profits.

After getting ravaged from 2000 to 2003, tech companies were more conservative in how they spent their money, so now they have outsized balance sheets. In the last six to 18 months, tech companies big and small have been deploying their balance sheets to create shareholder value.

In fact, tech companies in the S&P 500 have been the biggest buyers of their own stocks. In 2006, when stock-options expenses were recognized as actual expenses, we saw a change in behavior. Tech companies are compensating employees less with options and more with restricted stock. So companies are sitting on a lot of cash and are buying back more stock.