Capitalize on the tech sector slump

Tech stocks are out of favor, and cheap as a result. But the sector should get a boost -- starting in the year's second half -- as corporations start spending their IT budgets.

By StreetAuthority May 8, 2013 3:00PM
Investing in tech stocksBy David Sterman, StreetAuthority                                                           
This is not a good time to be running a tech company.

Corporate clients continue to withhold capital spending funds, investing only in areas that promise rapid payback or require modest sums to realize incremental improvements.

Additionally, spending by the U.S. government -- a major buyer of hardware, software and services -- has been nearly frozen as the sequester limits (or even shrinks) information technology budgets.

Adding insult, tech companies' foreign sales divisions in Europe and Asia are noting a high degree of spending caution.

How bad are business conditions? Based on updated second-quarter guidance, tech companies are expecting revenues to decline 5% year on year in the current quarter, according to Bloomberg. With the exception of a few quarters in late 2008 and early 2009, we haven't seen a drop like that since the dot-com implosion.

In response, major institutional investors have been steadily reducing their exposure to this struggling sector. Even as the Standard & Poor's 500 Index ($INX) has risen 13% since Labor Day, the SPDR Select Sector Fund Technology ETF (XLK) has not appreciated at all.

Follow the (IT) money
Counterintuitively, the rotation out of tech stocks creates a compelling opportunity. Though this sector is beset by near-term challenges, results should start to rebound later this year.

In most years, companies' chief information officers (CIOs) are allocated a certain portion of funds to work with. They often aim to spread out spending evenly over the course of a year, but every few years, spending gets off to a slow start as caution builds. However, CIOs know that when it comes to annual budgets, they must use it or lose it, and spending could spike sharply as we head into the fourth quarter.

That phenomenon, known as a "budget flush," was very pronounced most recently in 2009, as IT spending started off on a dismal note but finished with a bang. Notably, the SPDR Select Sector Fund Technology exchange-traded fund got off to a slow start in 2009 but finished the year with a 51% gain (compared with a 23% gain for the S&P 500).

Of course, we can't say for sure that global economic conditions won't weaken further this year, so a budget flush is not a given. Yet the primary reason for IT spending by both governments and enterprises is that it's a great productivity enhancement tool.

The U.S. government, for example, aims to deliver the same level of services with a reduced workforce, and the only way to do that is through technology-driven productivity increases. So deferred tech spending now should lead to a catch-up period later.

The relative under-performance of tech stocks has made them among some of the top bargains in the market. Many trade for only 10 to 12 times forward profits, and when you back out robust cash levels, those multiples fall into the single digits. Apple (AAPL) is a great example of a cash-adjusted bargain: Shares trade for 10 times forward earnings, but less than 8 times when cash is excluded.

          Cheap (and Deservedly So)
  
In this sector, it's not wise to seek out the most inexpensive stocks. These are the only tech stocks in the S&P 500 that trade for less than 10 times projected profits, yet almost all of them are beset by company-specific woes that are unlikely to dissipate, even when tech spending rebounds.

In this group, only Xerox (XRX) holds appeal, due to its stunning free cash flow. I'm also a fan of Jabil Circuit (JBL) for its outstanding management, but its hefty international sales exposure could be a problem in coming quarters. Keep an eye on this stock: If it moves into the lower teens (from its current $17.50), it would be a great long-term value.

If you move up to the next wave of inexpensive tech stocks, then you have a better chance of latching on to companies that will more squarely benefit from the eventual IT spending rebound. These tech stocks all trade for less than 13 times the projected profits for their current fiscal year.

      IT Spending Beneficiaries
                      

I remain a big fan of Cisco Systems (CSCO), my top pick for 2013. Additionally, any time that stocks like Oracle (ORCL), IBM (IBM) and EMC (EMC) are feeling the pressure of a weak recent quarter, that's often proved to be a good entry point, as these market dominators have proved to snap back nicely once the trough passes.

Of course, another major theme among tech stocks is their stunning cash balances and robust free cash flow. It's no coincidence that these are the companies leading the charge in terms of huge stock buybacks and solid dividend hikes. Here's a quick look at the most cash-rich tech companies in the S&P 500, in the context of their market values.



To reiterate, these stock's price-to-earnings ratios drop sharply when calculated on a cash-adjusted basis. The current rotation out of tech stocks gives these companies a chance to more aggressively deploy their cash into highly accretive stock buybacks.

Risks to consider: It's tricky to find a bottom for this sector, and the year-end budget flush may not play out if the global economy stumbles, so you should own these stocks with a multi-year time horizon.

Action to take:Tech stocks may not be timely, but they offer compelling values and still stand to generate much improved results once IT budgets loosen. Even if that doesn't happen until next year, these bargains may not last that long. Remember, investors always look ahead, and by the time investors get a sense that IT spending is on the cusp of an upturn, these stocks will already have moved up off of their lows.

David Sterman does not personally hold positions in any securities mentioned in this article. 

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