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A Magnificent Seven of Tech-Stock Value Plays


By Sam Jaffe Why do bad things happen to good people? If I knew the answer, I'd be a millionaire self-help author. But I do know why bad things happen to the stocks of good companies: economic downturns. And if you're a fan of the buy-low, sell-high concept, then you know that downturns are the best time to find good companies whose stocks are temporarily cheap.

For the past decade, that strategy has been hard to follow, considering that the U.S. hasn't had a recession since 1991. This means since most technology stocks weren't even around before that date, tech investors haven't had a chance to manage their tech portfolios in a buy-low manner.

Rejoice! The economy is dipping, the stock market is deflating, and for the first time in my memory, tech stocks are cheap -- across the board. That's why it's time to devise a tech-stock value screen to determine which companies offer the best value right now.

OMITTED PARAMETERS. Of course, value is a double-edged sword. Cheapness for the sake of cheapness is the kiss of death for many a portfolio. So I screened not just cheap stocks but those with a proven record of management effectiveness. Using a simple screening program available at Zacks Investment Research, I was able to narrow the 2,000 or so technology companies down to a final list of seven high-quality stocks that can be had for a bargain.

Before going into the details of the screen, let's start with what I didn't put in. One thing I avoided was the most overused -- and most useless in today's market -- ratio of them all: the price-to-earnings ratio. Because so many companies have had a dramatic dip in earnings in the past four quarters, p-e ratios are completely out of whack and don't come close to describing a stock's value. I also avoided screening for stocks that had simply fallen a lot. Because of this market's choppy nature, trend lines are all over the map. Also, the high prices that stocks fetched when the tech bubble was at its peak probably won't return anytime soon, so it's pointless to base their value from a starting point that was ridiculously high to begin with.

My first filter eliminated small stocks. Although plenty of values can be found in the small-cap arena, I wanted the big guys that will move up when the economy starts improving. I also wanted stocks that, despite the economic downturn, were still making a profit and had a price-to-sales ratio of less than 10. That cut the field down to 68 stocks.

ONLY THE BEST. At the heart of my screen was return on equity. This accounting metric is often described as a measure of upper management, because a company that is managed well will have a higher ROE. It's calculated by dividing the last four quarters of earnings by shareholders' equity, which is an accounting conceit that essentially measures all the accrued money that the company made after you subtract operating costs. The S&P technology sector has an average ROE of 11. I wanted only the best, so I chose only companies whose ROE was double that average. That left me with 23 stocks.

I wanted to make one last cut to make sure I was getting only bargains. But I didn't want to use the p-e ratio (because earnings are so peculiar over the last four quarters) or price-to-book value (because most of the value in technology companies lies in intangible assets, not physical assets). I settled on requiring my companies to have a price-to-cash-flow ratio of 30 or less, since the S&P technology sector has an average PCF of 30.

That left me with seven stocks. They're all companies that you're probably familiar with. A year ago, they might have been called the blue chips of tech. Today, they're more like the black-and-blue chips. But they'e all still very good companies, excellently managed, whose stock can be had for a low price because of the current market downturn. They span the breadth of the tech sector, from a wireless-handset maker to a digital-printing-software maker.

Together, they form a group of high-quality companies that play on the general technology downturn. Don't expect these stocks to immediately shoot back up to their highs. But if you're patient and have a long-term perspective, you won't find a better time to consider these stocks.

In alphabetical order:

Adobe Systems (ADBE): You'd be hard-pressed to find a safer Internet play than Adobe. Although it's hard to find a business model that works for the Net, hardly anyone is expecting the growth in the number of Web sites to slow. And Adobe software is used in almost every Web site. Although the company has seen some revenue slowdown this past year, it has been much less dramatic than for software makers in the B2B or personal-computer markets.

Applied Materials (AMAT): This is the undisputed king of the semiconductor-equipment makers. The current downturn in the chip cycle is the most severe in the industry's history, but that has been built into chip stock prices. At some point, demand will pick up again. And when that happens, the first to feel the results will be equipment makers like Applied.

Comverse Technology (CMVT): This company sells software and systems to wireless-service providers. Buying its stock is a way to play the long-term growth of the wireless industry without having to ride the roller coaster of handset sales or cuts in phone-service prices. As of Aug. 8, Comverse's stock was worth only 5% of its market capitalization at the time of its 52-week high last February.

Juniper Networks (JNPR): Juniper was one of last year's hottest companies and one of the last network-gear-maker stocks to fall to earth. Its sales growth has slowed, but it continues to steal market share from rival Cisco Systems (CSCO) in the high-end router market. It promises to be an industry giant by the time the networking-equipment market starts to grow again.

Nokia (NOK): When wireless handsets stopped selling in Europe this year, Nokia's stock dropped like a rock. But heavy discounts have finally cleared excess inventory, and the industry expects to post growth in the second half of this year. That's great news for Nokia, the No. 1 handset maker and technology leader in the wireless business.

Oracle (ORCL): "If you want to know when this [technology] recession is over, watch Oracle's sales. The moment corporations start spending on technology again, the first thing they'll buy is new software from Oracle," says Atiq Raza, CEO of venture-capital firm Raza Foundries. Less heralded than its consumer rival Microsoft (MSFT), Oracle has just as big a share of the all-important database market upon which most e-businesses are based.

ST Microelectronics (STM): This is another chip-industry play, but this company actually makes chips. It makes so many different types of semiconductors, from digital signal processors to memory to communications processors, that it's one of the few chipmakers that can serve as a proxy for the entire industry. Its management also has a firm track record of excellence.

So there you have it: A stock screen for the tech upturn -- though probably still not yet for the faint of heart. Jaffe writes about the markets for BusinessWeek Online


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