The neglected technology sector looks like a good candidate for an end of the year rally

09/20/2011 8:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

As technology rallies go, the rally of the last week and month is suggestive but not yet totally convincing.

For the week ended on September 16, a number of stocks in the sector such as Nvidia (NVDA), Intel (INTC), Oracle (ORCL) and Marvell Technology Group (MRVL) convincingly beat the 5.42% gain for the Standard & Poor’s 500 Stock Index. Nvidia was up 11.38%, Intel up 11.52%, Oracle 12.42%, and Marvell 10.81%, according to Morningstar.com.

That’s not especially surprising. High beta stocks, like most technology stocks, should rise faster than the general market when the broad market is climbing. Nvidia, for example, has a beta of 1.61, meaning that it is 1.61 times as volatile as the broad market. (By definition the broad market of stocks has a beta of 1.) Add in the way that technology stocks have been pounded in 2011--even after this rally Marvell Technology is down 18.22% for 2011 and Oracle is down 6.07%--and you’ve got a recipe for a tasty bounce.

But the technology rally is suggestive since it’s a reminder of the coming seasonal sweet spot for technology shares. Technology companies see a huge positive swing in revenue every year in the third and fourth quarters. I suspect we’re going to get some kind of November/December rally in stocks this year once the global economy (and especially the EuroZone)  has managed to survive September and October’s very rough spot without falling apart. The historical seasonal pattern for technology shares—added to the underperformance of technology stocks in 2011—will push the sector to the front in any rally. The sector’s performance could actually be quite explosive since the sector is under owned—for many investors technology shares have fallen off the radar screen—and any rally strong enough to generate “believers” will have a very strong bank wagon effect.

In most years sometime around October 20 or so is a good time for checking the technology weighting in your portfolio. This year last week’s rally says that you ought to start that checkup—and start adding to your technology weighting--a little early.

A technology rally would lift all boats but not equally. Microsoft (MSFT) was up only 5.36% last week, actually trailing the S&P 500 and Cisco Systems (CSCO) was up just 5.06%. On the other hand, Broadcom (BRCM) rose 6.67% and EMC (EMC) 6.9%, both more than the S&P 500.

I think this week’s rally in technology shares—even if it doesn’t hold long enough to roll right into an end-of-the year rally--provides a pretty good template for where to put your money this year. (Just to be completely clear, I’m not saying that the U.S. stock market is about to launch another big nine month rally or that any end of the year rally in U.S. stocks is sustainable. I think we’re all too aware of the big problems that are still lurking out there. All I’m looking for is a relief rally if, as I continue to think likely, European governments get their act together enough to kick the Greek and Italian debt crisis down the road into 2012 or 2013. In other words, don’t fall in love with anything you might buy now and look to take profits when the news flow of not-quite-so-bad-as-expected news starts to diminish in January or so.

Okay what did last week’s technology rally tell us about where to place our technology bets for the last quarter of 2011?

I’d divide the prospects for the sector into three parts.

First, the old technology giants are candidates for a bounce but that’s about all. I think you could get a bounce out of these stocks just because they’ve been so beaten up and investors are so familiar with these names, but the challenges facing these companies are enough to make them laggards in the sector. In addition their size makes finding new growth opportunities big enough to move the scale a difficult task.

In this group I’d put PC companies such as Hewlett-Packard (HPQ) and Microsoft (MSFT). PC sales aren’t exactly setting speed records. On September 17 the analysts at Gartner cut their projections for semiconductor revenue in 2011 to a 0.1% drop from 2010. Just in June Gartner had predicted that semiconductor revenue would climb by 5.1% for 2011.  The big culprit is the PC sector. Gartner cut its projections for unit growth in PC production to 3.4% for the year, down from 9.5% in its earlier forecast. Add in the drop in prices for much of what goes into a PC—memory chip prices, for example are falling—and you’ve got falling revenue despite a slight uptick in unit sales.

Big networking companies are seeing a similar slowdown. On September 13 Cisco Systems (CSCO) reduced its forecast for long-term revenue growth to 5% to 7% from as previous 12% to 17% estimate.

You can get a sense of how big any bounce might be by looking at the performance of Hewlett-Packard, up 4.42% and Cisco, up 5.06% in this rally. Both trailed the market but both stocks had been beaten up so badly in 2011 that they climbed with the sector. Even after last week’s rally Hewlett-Packard is still down 43.35% for 2011 and Cisco is down 17.25%.

Second, anything Apple has a chance to significantly beat the market—although suppliers to Apple (AAPL) might do better than Apple itself. In the recent rally shares of Apple climbed 6.1% while shares of a supplier such as Broadcom were up 6.6%.

In contrast to sales of PCs, not only is the tablet market growing but Apple’s iPad shows no sign of losing market share. For the company’s fiscal third quarter Apple reported 183% unit growth (179% revenue growth for the iPad.) Apple’s market share in the table market was a huge 68.3% in the quarter and the company saw market share for its biggest competitor, tablets based on Google’s Android operating system, actually lose share with the piece of the market owned by Android tablets falling to 26.8% from 34%. And rather than seeing new competitors dent its dominance, the news has been of competitors leaving the market (Hewlett-Packard and Sharp, for example), crashing on disappointing sales (sales of Blackberry PlayBooks have plunged to just 200,000), or receiving lukewarm reviews even before launch (Sony). No wonder that Apple, rather than rushing an iPad 3 to market to fend off competition, is sticking to its schedule for a 2012 update of the line. (The rest of Apple’s business isn’t doing badly either with iPhone sales climbing 142% in units and sales of desktops and notebooks increasing by 15% and 13%, respectively.

What’s truly amazing, however, is that while Apple the company has been scoring numbers like this Apple the stock still sells at just 16 times trailing 12-month earnings per share. I think investors can’t quite believe that someone isn’t about to kill Apple’s golden geese sometime soon.

But still Apple shares are up 24.16% for 2011 to September 16 and investors might do better in an end of 2011 rally with shares of a supplier such as Broadcom down 17.47% for 2011. Broadcom looks especially interesting because of a report last week from Taiwan Semiconductor Manufacturing (TSM), the world’s biggest contract maker of chips for other companies, that third quarter sales would exceed forecasts because of rush orders from an unnamed customer. Some of Taiwan Semiconductor’s customers have already preannounced disappointing sales for the period and analysts have pegged Broadcom, the largest Apple supplier among Taiwan Semiconductor’s customers, as the most likely candidate. Broadcom provides the Wi-Fi/Bluetooth chip for the iPhone. And Broadcom looks like it’s the supplier for the WAN cards in the newest version of Apple’s Airport router (replacing a Marvell Technology card.)

Taiwan Semiconductor itself has a strong Apple connection since the foundry looks like it will pick up substantial chip orders from Apple for the next generation A6 processor that will be used in the iPad 3. Samsung is Apple’s major current supplier for this CPU (central processing unit) but Apple is engaged in a bitter patent fight with Samsung over that company’s own Galaxy tablet.

Third, storage, storage,storage—and making it more efficient. The names I’d watch here are EMC (EMC) and VMware (VMW), although since EMC owns 80% of VMware, you can cover both bases with just EMC. Digital data, which needs to be stored somewhere, is growing at roughly a 40% annual rate. The key to this game isn’t the hardware but the software that manages the data, de-dupes it, allocates machines to data, schedules data tasks and the like. EMC trades at 22 times trailing 12-month earnings per share and the consensus Wall Street estimate pegs earnings growth at 17.4% for 2011. I’ve got some worries about VMware’s ability to defend its turf against companies such as Microsoft that are building more virtualization software into existing products to enable storage systems to set up virtual machines to more efficiently allocate tasks among systems, but remember that this is all about a relatively short-term rally in the technology sector.

This is how I handicap an end of the year technology rally currently. The next few weeks should tell investors how likely that rally might be and whether investors will have to suffer through another dip in the sector before getting a move higher.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of Apple and EMC as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

 

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