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When it comes to technology stocks, investors have their heads in the cloud. According to some of the technology portfolio managers whose mutual funds drew the highest scores from Bloomberg Rankings as of September 2010, the hot theme in technology is cloud computing, in which hosted services such as communications infrastructure, software, and data storage that used to be accomplished locally, on servers, are delivered via the Internet.
This a highly strategic area for many larger-cap technology companies that see the growing importance of top-notch data centers, says Charlie Chai, manager of the Fidelity Select Technology Portfolio (FSPTX). "They feel storage is critical to build out a successful cloud offering," he says.
During the third quarter, the valuation gap widened between small- and mid-cap technology companies that are tied to trends such as cloud computing and the large legacy companies that are viewed as less nimble and focused on serving slower-growing markets, says Jeffrey Donlon, portfolio manager of the Manning & Napier Technology Series Fund (EXTCX). Shares of F5 Networks (FFIV) and Aruba Networks (ARUN) surged 51.4 percent and 49.9 percent, respectively, while Cisco Systems (CSCO) rose 2.8 percent and Intel (INTC) fell 1.3 percent.
Of Standard & Poor's six North American technology sector indexes, the Internet index performed best, both year-to-date as of Oct. 15 (up 25.5 percent) and in the third quarter (up 29.6 percent). The Semiconductor index was weakest, down 1.6 percent year-to-date, and up 8.1 percent in the third quarter.
Although stronger business fundamentals were working in their favor, the price-to-earnings multiples for such companies as Salesforce.com (CRM) and Akamai Technologies (AKAM) expanded much more dramatically than underlying earnings during their third quarters, says Chai. Valuations for semiconductor manufacturers were flat, or even contracted slightly, he adds.
Data storage stocks had an impressive run in the September quarter, attributed mostly to rising takeover premiums as investors watched the bidding war between Hewlett-Packard (HPQ) and Dell (DELL) for cloud specialist 3PAR. The company's stock tripled in a month before Hewlett-Packard emerged victorious on Sept. 24. Some of the froth came off the storage stocks on Oct. 6, after Equinix (EQIX) lowered its third-quarter revenue forecast by 2.2 percent and cut its fiscal year outlook by 12 percent, to roughly $1.22 billion. Fidelity's Chai believes this is only "year two or three" of a 10-year architecture shift toward cloud computing.
Large companies in developed countries, eager to cut costs because they're concerned about the softer economic outlook, are turning to cloud-based information technology, which is cheaper than owning and managing their own infrastructure. It's also more practical amid the proliferation of assorted computer formats that employees are bringing to work and asking employers to enable, says David Eiswert, manager of the T. Rowe Price Global Technology Fund (PRGTX).
The diversity of employee-owned gadgets with professional applications has companies' information technology executives struggling to keep up, says Barry Mills, co-manager of the Dreyfus Technology Growth Fund (DTGRX). "If a company can host the application in the cloud, then they can be completely agnostic about how an employee is accessing the cloud, whether PC or tablet," he says. "The reason tablets are taking off is that employers are embracing them."
Mills estimates that tablet sales could top 40 million units in 2011, which would eat into sales of netbooks and laptop computers. That bodes poorly for laptop makers such as Dell and Hewlett-Packard and for such netbook manufacturers as Acer (2353:TT), Asustek (2357:TT), and LG Electronics (066570:KS).
Elsewhere in the tech industry, well-established companies are scrambling to increase their data service offerings. Chai expects to see more merger and acquisition deals, not only among storage companies but also in software and mobile computing, including Wi-Fi, wireless security, and infrastructure around mobile broadband. The announced $1.7 billion acquisition of Netezza (NZ) by International Business Machines (IBM) will make it easier for IBM to compete with Oracle (ORCL) and Teradata (TDC) in more comprehensive data products, RBC Capital Markets said in a Sept. 20 research note. Oracle, Dell, and Xerox (XRX) have all recently made acquisitions in an effort to integrate their hardware and services offerings, said RBC.
The innovation that's occurring is creating new markets and new companies while hurting existing companies, says Matt Griffin, co-portfolio manager of Dreyfus Technology Growth Fund. "Half the battle is avoiding those companies exposed to negative trends," such as original equipment manufacturers still focused on traditional telephone handsets, he says.
Donlon believes the market is underestimating the earnings capacity of some larger, well-established companies, however. That provides opportunity for investors to buy large-cap vendors that are exposed to the same trends as smaller companies whose shares have climbed too high, too soon. He thinks Cisco may be able to increase its earnings by 10 percent to 15 percent annually, which isn't as enticing as the 30 percent to 40 percent growth range among some smaller stocks that were bid up during the summer.
The expected inventory buildup in the PC industry has quelled the market's appetite for semiconductor manufacturers. Reduced earnings forecasts by these companies are a buy signal for Eiswert at T. Rowe Price, who believes inventory corrections are largely priced into the stocks already. "We think investors should embrace it" and buy the ones with the biggest downward revisions, he says. "After the companies guide [earnings forecasts] down, they're all going to go up."