11/22/2011 2:55 PM ET|
Are tech stocks the new safe haven?
Security-seeking investors like Warren Buffett used to turn to the makers of necessities like toothpaste and soap. Here are 5 tech stocks that appear to offer safety now.
Are computer chips and software code now as safe as shampoo and laundry detergent?
After all, these companies get dependable revenue by selling stuff people keep buying even during hard times -- like baby shampoo, Crest toothpaste and Tide detergent. In fact, this "recurring revenue" is a big reason these two companies are major positions for Berkshire Hathaway (BRK.B, news).
But tech stocks? If you've ever lost money in roller-coaster technology stocks, you might not think of them as safe havens.
It's time to rethink that.
As the Oracle of Omaha's move into IBM and Intel suggests, many tech companies are actually as "defensive" as businesses selling paper towels and razor blades. In short, they provide stability in a volatile market, with the potential for decent upside because they sell products that companies and consumers need.
Buffett is not the only one who thinks so.
At a presentation in New York City last week, James Swanson, the chief investment strategist at MFS Investment Management, made the case for investing in tech as a defensive move to cope with the market and economic uncertainty that 2012 will surely bring. "We always thought of technology as highly charged, but the tech sector is much more defensive than it used to be," says Swanson.
That's because a lot of tech companies boast qualities that make them safe, says Swanson. First, they have financial strength based on dependable cash flows, solid profit margins, built-in recurring revenue and lots of cash. Next, they have a global reach, which eliminates exposure to any one country's business cycle. And many even have arguably cheap valuations, which may protect against declines during market sell-offs.
All of this brings relatively low volatility -- a nice quality when wild weekly market swings bring stress.
In contrast, many of the traditional "defensive" plays in health care and basic consumer goods face uncertainties like questions about government's role in health care and sharp commodity price swings, says Swanson.
The right techs for safety
Of course, not just any tech company can provide safety in a storm. A new startup with a hot product can flame out fast or tank on an earnings miss. For safety, with the potential for growth, you have to look among the tried-and-true tech survivors, or the tech "dinosaurs," as Todd Lowenstein, portfolio manager of the HighMark Value Momentum (HMVMX) fund, calls them. By that, he means the bigger tech companies like IBM and Intel that survived the tech bubble and continue to serve established markets.
The tech dinosaurs are often viewed as has-beens. "There is the perception that they will not participate in the next trend," says Lowenstein. These dinosaurs, however, typically have entrenched positions in their markets that allow them to produce solid profits and cash flows. And, as we will see, many of them are participating in some hot trends, so there's the potential for decent growth, too.
Besides IBM and Intel, I'll put EMC (EMC, news), a storage company, on a short list of "defensive" tech plays, as well as Cognizant Technology Solutions Cognizant Technology Solutions (CTSH, news), which provides software development, maintenance and testing services. I'm also including Apple (AAPL, news). It's not really a dinosaur, of course, but the stock looks cheap, and it has many of the other characteristics of defensive tech plays.
Let's take a look.
A core feature of defensive tech companies is that they have lots of cash. This reduces risk of bankruptcy or having to raise cash on terms that water down the value of their stock.
The numbers tell the story. Overall, tech companies have more cash than any other sector in the Standard & Poor's 500 Index ($INX). Tech-sector companies have cash worth 18% of their market cap, according to Standard & Poor's. The next-closest sector is health care, with 16%. All other sectors are at 10% or below.
And a strong cash position is a key feature of the five defensive tech plays I'm citing here. Apple, for example, has $28 billion in cash and short-term investments, and an additional $48 billion in long-term investments, according to Morningstar. The company has no debt. Intel has about $15 billion in cash; IBM has about $11 billion; EMC has around $4.7 billion; Cognizant has around $2.3 billion and no debt.
A big part of the reason tech companies have so much cash is that for most of them, their main assets are their employees, as opposed to expensive factories and equipment, says Jeffrey Provence, who manages the Wireless (WIREX) fund. But the defensive tech companies I'm citing here also have a lot of green, because they all produce so much cash flow. This is partly due to high profit margins, typical of tech companies and also a defensive characteristic. After all, with high profit margins, it's easier to continue making profits during a downturn.
But our defensive tech plays also have strong cash flow because big parts of their businesses produce recurring revenue, another safety feature of these companies. Buy one Apple device, for example, and you get drawn into the Apple ecosystem so the next time you buy a new device, it's likely to be an Apple, since going to a competitor is a hassle.
Because IBM sells mainframes, servers, storage systems, business software and chips, it also tends to lock in customers, which is probably a quality that attracted Buffett to the stock, says Lowenstein. "IBM is a safe-haven investment, given the high recurring revenue," he says.
About 80% of the revenue at Cognizant is recurring revenue from services such as maintenance, says Swami Shanmugasundaram, who follows the company for Morningstar. Similarly, EMC enjoys repeat business because companies design their entire datacenters around EMC software and hardware -- and that is not a decision they are apt to change from year to year, says Michael Holt of Morningstar. "There is a built-in customer loyalty," he says.
Next, the companies on our defensive tech list look fairly secure because they do so much business around the world, so they aren't exposed to any single business cycle. While the economy in the U.S. or Europe may be weakening, there's still robust growth in emerging markets like China, India and South America. This helps explain why, during the last recession, earnings and cash flow declined less at many tech companies compared with other sectors, says Swanson.
Aside from Apple, which says that 61% of its sales come from outside the U.S., tech companies don't necessarily reveal how much of their sales originates overseas. And it's hard to determine anyway, since computer chips sold in the U.S. by Intel may eventually wind up in products bought overseas.
But it's safe to assume that tech giants like Intel and IBM do lots of business abroad, and the big-picture numbers confirm the story. U.S.-based tech companies get more revenue from foreign lands than any other sector in the S&P 500. Last year, tech companies got 56% of their revenue abroad, while the runner-up, materials, got 52.5%, says Howard Silverblatt of Standard & Poor's. All other sectors got less than 50% of their sales abroad.
Finally, our defensive tech plays look safer because they are fairly cheap. This may protect investors, because cheap stocks often fall less in market declines and rebound faster, says Provence. "And if they have a miss on revenue, it shouldn't hurt the company as much because they are already trading at a discount," he says.
To measure valuation, I'll use Peter Lynch's preferred price-to-earnings-to-growth ratio, which you get by dividing a company's price-earnings ratio by its growth rate. The S&P 500 currently has a PEG ratio of just over 1. Apple trades well below that, with a PEG ratio of 0.57. Intel and EMC come in below the market multiple with peg ratios of 0.89 and 0.9, respectively. IBM and Cognizant carry PEG ratios slightly above the market's.
"They are not cursed with high expectations," say Lowenstein. "So you are getting better-than-average growth at a lower price, and we like that kind of combination."
While valuations are cheap because tech investors view these companies as dinosaurs, in many cases they are exposed to the hot trends like cloud computing (the use of centralized computing to power business software services or mobile devices).
Take Intel, for example. "The knock on Intel is that it is tethered to the PC ecosystem," says Lowenstein, whereas the big growth in consumer electronics is in mobile phones and tablets. But Intel uses its financial clout (remember all that cash?) to fund massive research efforts that are helping it become a significant player in low-power chips for tablets and other mobile devices. "The market is not giving them any credit for that," says Lowenstein. Intel is also a play on cloud computing because servers are key in that trend, and chips for servers are Intel's bread and butter. Besides, the PC is not going away. "The core business keeps chugging along," says Lowenstein. "The risk-reward for Intel is very attractive."
Similarly, IBM may look like a boring mainframe company, but it also has a hand in cloud computing through server and software offerings.
EMC has a growth angle, too, because the amount of data created by companies will grow at about 40% a year for the next several years, says Morningstar's Holt. "All that data has to go somewhere. They are solving a problem that doesn't necessarily ebb and flow with the business cycle."
Cognizant delivers much of its software development from India. With companies looking to contain costs in a tough economy, they'll turn to Cognizant for lower prices.
And a risk at Apple is that it just lost Steve Jobs. "But there are several products in the pipeline that Jobs was a big part of," says Provence. "And there are plans for additional products down the line that he had his hands in."
Despite this potential, Apple stock trades for 9.5 times next year's earnings. "Unless there's a huge miss on revenue, which I don't anticipate, that's a pretty cheap," says Provence.
So, are all the stocks of all these tech companies really "safe"? There's an app for that. As one measure of safety, investors like to look at a stock's "beta," a measure of how much a stock moves along with the market. A stock that normally moves in line with the market has a beta of 1, whereas a stock that moves up or down much more than that the market has a beta well above 1. With the exception of Intel, which has a beta of 1, all of our safe-haven tech stocks have betas below 1, with IBM the lowest at 0.49, followed by Apple at 0.89, Cognizant at 0.91 and EMC at 0.95. There's safety in those numbers.
At the time of publication, Michael Brush did not own or control shares of any company or fund mentioned in this column.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
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Tech stocks...really! This is the way out? Are there not more pressing things to be addressed. Europe is collapsing under insurmountable debt and two dictators have been installed in place of elected officials. Housing continues to fall. The stupid committee could not agree to cut 1.2 trillion (peanuts) over a TEN YEAR period on a debt that is currently 15 TRILLION. Bernanke is echoing thoughts of QE3, another round of make believe stimulus to borrow more from the dwindling tax payers to pay the interest on what already has been borrowed. How has this worked so far? Corrupt politicians, captured media, an attorney general that refuses to prosecute a fraudulent banking system and there is so much more, but people seem to be happy watching NFL and Dancing with the Stars. I think some real honest talk on how to prepare one's self for the 2nd great depression would be in order.
iowaview; It's not a left, right thing, both parties are money whores and both are owned by the lobbiests and banking cartels. The key would be to separate the money from the politics (not an easy task, but doable). Once you get rid of the central bankers the system could work again. We've become a government for the banks, by the banks and of the banks.The Federal Reserve is the cancer that just keeps on growing.
Doug: can't argue with what you pointed out..and my comments were meant to be global as today's issues will effect the entire world.
so much for tech stocks.............??
I think some real honest talk on how to prepare one's self for the 2nd great depression would be in order.
Fastback49 .. Looking around the world, I think more than "just one's self" ought to be in on the conversation, about what to do with the adjustment in these depressing financial times. The sad part about watching things unfold, is that It could have been prevented with bold measures from some statesman in Congress (fiscal policy) .. and some common sense in Europe instead of the picket fence attitude.
I don’t see a whole lot of upside in the tech sector for quite some time. I only see huge amounts of risk. Oh, well where fools rush in. Knock yourself out, but when labor shortages cap growth, skyrocketing labor costs sap earnings, bitter labor strife affects production schedules, and other mismanagement whip saws your tech portfolio in comming years don’t say I didn’t tell you so.
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