How to Profit from the Growing Divide in Tech Stocks. – Barron’s

For years, investors bid up tech stocks on the idea that digital transformation was inevitable. The Covid-19 crisis has proved them right.

We have seen two years worth of digital transformation in two months, Microsoft CEO Satya Nadella recently told investors.

But the acceleration creates questions: How much growth is left? And has it all been priced in? The Nasdaq Composite is up 12% on the year, versus a 4% decline for the S&P 500 index.

Ive been following tech for 41 years, and this is the second most expensive tech market Ive ever seensecond only to the internet bubble 20 years ago, says Fred Hickey, editor of the High Tech Strategist, a monthly newsletter. Hickey has long been skeptical of tech valuations, but this time the fundamentals are on his side. The Nasdaq Composite currently trades at 3.4 times forward sales, well above a 10-year average of 2.3, according to FactSet.

The issue for investors is that fundamentals often dont apply to tech stocks. During the pandemic, investors that bought high-price tech stocks have been richly rewarded. Steve Milunovich, the technology strategist at Wolfe Research, makes the remarkable observation that tech stocks that entered 2020 with a price-to-sales multiple of 10 times or higher have gained 35% on the year. Momentum has taken over. While price/earnings is the most common valuation metric in investing, investors often use sales multiples for tech companies since earnings can be depressed, or nonexistent, during periods of high growth.

Ted Mortonson, technology strategist at Baird, the Milwaukee-based investment firm, says there are good reasons for elevated valuations. He says that were in the most powerful integrated technology growth cycle since the late 1990s, pointing to the acceleration of cloud computing, e-commerce, and telehealth, and the arrival of fifth-generation, or 5G, wireless and new chips. It all adds up to big growth potential at a time when theres limited growth in other industries. Growth investors have bought tech stocks, he says, because theyve had few other choices.

But Mortonson also sees risks. If one or more cloud players disappoint during the next round of earnings reports, the stock reversal could be severe. He advises keeping an eye on secondary data points like billings, contract duration, and deals time-to-close. He fears that investors may not be factoring in the impact of unemployment on companies with per seat revenue models. There are a lot of knowledge workers off the payroll, he says. Mortonson also sees risks ahead for subscription-based cloud services as renewal cycles heat up in the second half.

As those risks mount, valuations could resume their importance. So, Barrons went looking for cheap tech. We searched for U.S. technology stocks with market values of more than $5 billion and growing sales in the current fiscal year. That revenue requirement excluded some of the cheapest stocks in tech, including Dell Technologies (ticker: DELL), HP Inc. (HPQ), and Hewlett Packard Enterprise (HPE). We then ranked the results by price-to-sales multiples, using current fiscal-year revenue estimates.

*Based on current fiscal years estimated revenue

Source: FactSet

The screen is revealing: There are still a few cheapand growingtech companies to be found. Disk-drive maker Western Digital (WDC) trades for less than one times sales. Rival Seagate Technology (STX) is just a bit higher at 1.2. Accenture (ACN), the information-technology consulting firm, is at 2.9. Meanwhile, chip giant Intel (INTC) and MKS Instruments (MKSI), a maker of chip-making tools, trade at less than 3.5 times. F5 Networks (FFIV), which helps companies digitally distribute software, trades at 3.7 times this years sales.

The list of high-multiple names wont come as a surprise to anyone who has been keeping tabs on the markets obsession with work-from-home plays. In fact, the roster is a whos who of cloud-based software stocks, companies like Datadog (DDOG), Zoom Video Communications (ZM), Coupa Software (COUP), Okta (OKTA), and Cloudflare (NET). Their financial results are sterling, but their valuations are no longer tied to fundamentals.

Value investors can still find a home in tech, though. The disk-drive makers on our cheap list could be a compelling opportunity in the year ahead. Western Digital shares have been hurt by the companys May decision to suspend its quarterly dividend and redirect the cash to paying down debt from the companys 2016 acquisition of SanDisk for $19 billion. The deal, while expensive, remains a shrewd diversification move, giving the disk-drive maker an important role in superfast solid-state drives.

Milunovich says that Western Digital should benefit in the back half of the year from an expected pickup in flash-memory pricingand hes bullish on the companys new CEO, former Cisco executive David Goeckeler. Unlike some other legacy tech companies, meanwhile, Western Digitaland Seagateremains relevant in a cloud-based world. Their drives are still necessary for cloud-based computing and storage.

Three of the names on our cheap-tech list come from the IT consultancy arena. Two of them are government-focused IT services contractors CACI International (CACI) and Leidos Holdings (LDOS)and both are growing sales more than 10% annually.

The other is Accenture, a broad-based provider of tech consulting services. Accenture tends to work on-site with clients, and those consultants are largely grounded, as is the stock. But once the economy rebounds, the push toward digital transformation should keep Accentures consultants busy, boosting the stock.

Finding a longtime tech leader like Intel among a list of cheap stocks might seem surprising, but the company has been battered by a combination of market share losses to Advanced Micro Devices (AMD) and ongoing manufacturing issues. Other recent headlines havent been kind to Intel, including reports that Apple (AAPL) is ready to design its own processors for some of its Mac computers.

But Intel still controls 95% of the market for server processors and more than 80% of the PC processor market. Despite the current issues, Intel shares remain a compelling bet on the future of computing. This past week, KeyBanc Capital Markets raised its rating on the stock to Overweight from Sector Weight, noting that Intel should benefit from its push into markets beyond PC microprocessors, including data centers, artificial intelligence, 5G, and the Internet of Things.

F5 Networks is one of the smaller names on our cheap-tech list. The company makes software that accelerates the performance and security of web applications, and its in the middle of transitioning to a subscription-based model. Those transitions are painful in the near term, but they usually prove rewarding for investors over time.

Evercore ISI analyst Amit Daryanani recently wrote to clients that he sees potential for a much higher stock price as F5 shifts to a recurring revenue modelmore like the cloud-based names on the other end of our screen.

MKS Instruments, meanwhile, is a longtime player in the semiconductor equipment industry that has expanded into optical components. This week, Needham analyst James Ricchiuti picked up coverage of the stock with a Buy rating. He contends that MKS is a rare company that does M&A well. The expansion into optical parts like lasers has reduced the cyclicality of its business.

One of the ironies of tech is that even the companies battered by the cloud have significant cloud exposure these days. Intel processors are used in cloud-based servers. Seagate and Western Digital drives are used in cloud storage; F5 is trying to evolve into a cloud-style business model. And Cienas networking components are finding strong demand from cloud leaders like Amazon.com (AMZN), Facebook (FB), and Alphabets Google (GOOGL).

The cloud is now everywhere, and at some point it could even lift the stocks of the cheapest tech names.

Write to Eric J. Savitz at eric.savitz@barrons.com

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How to Profit from the Growing Divide in Tech Stocks. - Barron's

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