Tempted By Technology

9/17/2012


The S&P 1500 Technology Sector Index has returned 21% so far this year, topping the 16% return of the broader index.

Tech's outperformance may not surprise you, but this probably will: Makers of computer hardware and equipment, products thought to be facing slack demand, paced the growth. The Hardware & Equipment Group has posted a 29% return so far this year — and also outperformed the other two major technology groups over the last three and 10 years. Software & Services has managed a 19% return this year, while Semiconductors & Semiconductor Equipment has returned just 3%.

But before you load up on computer stocks, let's dig a little deeper. Apple ($661; AAPL), up 63% so far this year, accounts for more than 40% of the total stock-market value of the Hardware & Equipment Group. Exclude Apple, and the group's year-to-date return is 8%.

Apple's outsized effect on sector returns serves as a warning to tread cautiously. Technology is too important a sector to misread. The S&P 1500 Index of large, medium-size, and small stocks contains 267 tech companies, nearly 18% of the index's count. Tech stocks account for 20% of the index's total stock-market value. Yet tech companies average Quadrix® Overall scores of 53, below the average of 57 for the broader index. Only utility stocks average lower scores. Tech is known for its growth, yet the sector's average Momentum score of 42 is the lowest of any sector.

Despite these unimpressive numbers, the Forecasts recommends 10 technology stocks, which account for 26% of our Buy List and 24% of our Long-Term Buy List. Why so many? Here are four reasons:

We find a lot of appealing names. Only 19% of tech stocks in the S&P 1500 earn Overall scores above 80; but that still equates to 51 companies, giving us plenty of choices.

Big techs stand out. These days, we see a lot to like in the largest stocks — U.S. companies with stock-market values above $100 billion average Overall scores of 66. And among those big boys, tech stocks (nearly one-third of the companies in that group) look particularly impressive, averaging Overall scores of 87 and Quality scores of 92. Relative to the largest stocks, techs also earn higher-than-average Momentum and Value scores.

Quadrix works particularly well for tech stocks. In back-tests since 1994, the top one-fifth of S&P 1500 technology stocks as measured by the Overall score outperformed the average tech stock by 3.4%. Only in the materials and consumer discretionary sectors did Quadrix leaders enjoy greater outperformance.

Tech truly is a growth sector. Analysts project per-share-profit growth of 13% for the S&P 1500 Technology Sector this year and 19% next year. The 34% growth expected between 2011 and 2013 is the highest of any sector.

TECH STOCKS WE MONITOR
Sector-Specific
----- Scores -----
Company (Price; Ticker)
Quadrix
Overall
Score
12-
Factor
Sector
Reranked
Overall
Industry
Advice
Accenture ($65; ACN)
74
47
74
IT Services
A (above avg.)
Adobe Systems
($32; ADBE)
77
45
76
Software
B (average)
Alliance Data Sys.
($141; ADS)
82
80
81
IT Services
Focus Buy *
Altera ($37; ALTR)
41
48
36
Semiconductors
C (below avg.)
Apple ($661; AAPL)
97
97
99
Comp. & Periph.
Focus Buy *
Applied Materials
($12; AMAT)
44
34
46
Semiconductor Eq.
B (average)
Auto. Data Process.
($59; ADP)
44
21
51
IT Services
B (average)
Cisco Systems
($19; CSCO)
98
96
97
Commun. Equip.
Buy *
Cognizant Tech.
($67; CTSH)
92
95
83
IT Services
A (above avg.)
Corning ($13; GLW)
64
64
52
Electronic Equip.
B (average)
Dell ($11; DELL)
50
54
31
Comp. & Periph.
B (average)
eBay ($48; EBAY)
68
32
88
Internet Software 
A (above avg.)
EMC ($27; EMC)
88
74
84
Comp. & Periph.
Buy *
Google ($692; GOOG)
91
97
95
Internet Software
Focus Buy *
Hewlett-Packard
($18; HPQ)
38
62
23
Comp. & Periph.
B (average)
IBM ($203; IBM)
79
16
68
IT Services
B (average)
Intel ($23; INTC)
77
47
70
Semiconductors
L-T Buy
MasterCard ($443; MA)
63
34
64
IT Services
B (average)
Microsoft ($31; MSFT)
83
69
85
Software
Buy *
Motorola Solutions
($49; MSI)
47
20
40
Commun. Equip.
C (below avg.)
Oracle ($32; ORCL)
93
90
95
Software
L-T Buy
Qualcomm ($62; QCOM)
76
63
72
Commun. Equip.
Buy *
Research In Motion
($7; RIMM)
37
85
21
Commun. Equip.
C (below avg.)
SAP ($69; SAP)
59
6
56
Software
B (average)
Texas Instruments
($29; TXN)
36
23
27
Semiconductors
C (below avg.)
Visa ($131; V)
73
21
80
IT Services
Buy *
Notes: Quadrix and sector-specific scores are percentile ranks, with 100 the best. 
* Also qualifies as a Long-Term Buy.    Recommended stocks in bold.

The table above lists all of our monitored tech stocks. Our four favorites are reviewed below.

At 17 times trailing earnings, Alliance Data Systems ($141; ADS) trades roughly in line with the median provider of data-processing services despite its impressive profit outlook. Per-share earnings rose at an annualized rate of 19% over the last five years, and the consensus projects growth of 12% this year and 14% next year. Alliance has historically commanded a premium to its industry, and the current P/E ratio is 21% below the company's three-year average.

Alliance, which provides credit-card and loyalty programs and marketing services, announced several new deals during the quarter, saying the pipeline remains rich. Profit at the private-label credit-card business jumped 26% in the quarter on a mix of strong portfolio growth and improving credit quality. Aggressive expansion in Brazil and the acquisition of card portfolios in the U.S. should also help keep the growth coming. Alliance is a Focus List Buy and a Long-Term Buy.


In July, Apple ($661; AAPL) announced June-quarter sales and profits that lagged market expectations and provided growth targets well below the consensus. Of course, Apple's version of disappointing results is sales growth of 23% and per-share-profit growth of 20%, numbers none of its largest computer-hardware rivals has delivered in nearly a decade. And while profit estimates have fallen, the consensus still projects growth of 19% in the September quarter and 20% in the fiscal year ending in September 2013. Since the warning, Apple's shares have risen 15%.

Apple is now best known for its smartphones and tablets, but its roots are in personal computers. And at its core, Apple remains a computer maker, even if most of those computing devices are small. However, Apple's ability to create groundbreaking products has provided a competitive advantage. By one estimate, the market for high-end smartphones (devices selling for at least $400) is expanding at an annual rate of more than 40%, and Apple controls nearly half of that market. On Sept. 12, Apple released its latest smartphone, the iPhone 5, which runs on a faster wireless network than prior models. Apple is a Focus List Buy and a Long-Term Buy.


Data-storage company EMC (27; EMC) has reeled off double-digit sales growth in 10 straight quarters, as operating profit margins steadily expanded. In each of the past five quarters, cash provided by operations rose at least 16% and free cash flow at least 29%.

Last year, former partner Dell ($11; DELL) trespassed on EMC's turf by pushing into the storage industry. This year, current partner Cisco ($19; CSCO) threatens to do the same. So EMC has found a new ally in Lenovo Group; together they will sell storage equipment and servers to small and midsize companies, which should expand EMC's presence in China. EMC could also put its cash to work by enlarging its security business. The company has made 15 acquisitions in the past three years, and its return on assets keeps marching higher, suggesting it has integrated purchases well.

The stock trades at 17 times trailing earnings, well below its five-year average of 23. Should EMC meet the 2012 consensus profit estimate of $1.72 per share (implying 14% growth) and its P/E ratio reach 19, the shares will climb 20% by early 2013. EMC is a Buy and a Long-Term Buy.


The last time Google ($692; GOOG) failed to deliver quarterly sales growth of at least 22% was the December 2009 quarter, an eternity in tech time. In 2009, Google's operations centered around its ubiquitous search engine. Google still generates 90% of its revenue from online advertising, but the company now owns hardware businesses via its purchase of Motorola Mobility. And in the June 2012 quarter, Google's Android operating system captured about two-thirds of the global smartphone market.

Critics have questioned the wisdom of Google's May purchase of Motorola Mobility for $12.5 billion, citing the possibility of lower profit margins and slower growth. But analysts still project per-share-profit gains of 18% this year and 16% next year. Motorola owns a collection of patents to help defend Google from legal attacks, and over time the smartphone- and tablet-manufacturing business should provide new revenue streams and reduce the company's dependence on others to make its devices. Earlier this month, Google introduced its first three Motorola smartphones since the acquisition, gearing up for the holiday season. Google is a Focus List Buy and a Long-Term Buy.

TECH SECTOR ANALYSIS
As a group, technology stocks earn mediocre Quadrix scores, with software & services looking better than most and semiconductors & equipment displaying the weakest fundamentals. Tech stocks' average price/earnings ratio of 19.5 is comparable to the average for S&P 1500 Index constituents; historically tech stocks have averaged higher valuations. All of the data below other than the company count and stock-market value represent averages.
Total Return
Stock-Market
Value, In $Bil.
(% Of Tech
---- Sector) ----
12-Month
-- Growth --
Annual.
--------- Quadrix Scores ---------
Sector-Specific
----- Scores -----
Index (No. Of Companies)
Sales
($)
EPS
(%)
YTD
(%)
3
Yrs.
(%)
10
Yrs.
(%)
P/E
Ratio
Momen-
tum
Value
Quality
Overall
12-
Factor
Sector
Reranked
Overall
Technology Sector (267)
2,989
(1)
6
(4)
10
11
10
19.5
42
51
63
53
50
50
   Software & Svcs. (115)
1,496
(50)
14
11
17
18
14
20.3
56
47
73
63
52
62
     Internet Soft. (25)
310
(10)
18
23
15
19
20
21.4
60
50
74
64
56
64
     IT Services (41)
566
(19)
11
11
18
16
9
17.8
61
53
73
69
59
69
     Software (49)
620
(21)
13
5
18
20
15
22.1
51
39
72
57
45
57
   Hardware & Eq. (90)
1,173
(39)
6
(5)
4
7
9
17.0
37
59
57
51
52
45
     Commun. Eq. (24)
265
(9)
4
(8)
1
6
8
19.2
35
52
51
44
51
39
     Comp. & Periph. (20)
791
(26)
10
3
5
5
12
15.0
43
60
61
55
60
49
     Electronic Equip. (46)
117
(4)
5
(7)
6
9
8
16.6
34
62
59
53
49
46
   Semicond. & Equip. (62)
319
(11)
(7)
(36)
4
5
5
21.7
23
46
54
39
42
34
     Semiconductors (41)
275
(9)
(4)
(32)
4
4
5
21.9
25
43
55
37
41
32
     Semiconductor Eq.(21)
45
(1)
(15)
(43)
3
7
4
21.1
20
52
52
41
45
37
S&P 1500 Index (1,500)
15,214
(NM)
8
6
14
13
10
19.2
51
54
59
57
50
49
Notes: Returns and growth rates above 100% and P/E ratio below 0 or above 75 excluded.   Quadrix scores are percentile ranks, with 100 the best.     NM Not meaningful.

 


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