Currency Trading

By
Tara Kalwarski

The S&P 500 information technology index rose 61% in 2009, so it’s reasonable to ask if, in 2010, tech stocks have anywhere to go but down. Dig into the data, though, and you’ll find reason for optimism. Prices are at about the same level they were in early 2008, and after recent boosts in earnings forecasts, the companies trade at about 14.8 times projected earnings, down from 16.9 two years ago.

Last year’s tech juggernaut was packed with lower-quality stocks, particularly in semiconductors, that had been battered in the downturn, says Fidelity Select Technology manager Charlie Chai. This year he predicts the leaders will be higher-quality companies “that put up sustainable growth.” That outlook assumes a continued economic recovery. If no large bumps in the road emerge, here’s how pros think tech stocks will play out.

LEADING THE CHARGE

Tech companies depend on four types of buyers: consumers, businesses, the telecom industry, and governments—each of which has cut back on spending. Consumers remain constrained by job worries, telecom customers are spending less, and government budgets are a mess. That leaves corporations to lead the charge back into tech, says Richard Parower, manager of Seligman Global Technology. Hardware and software companies are most likely to benefit. “A lot of people have outdated equipment and software,” says Zachary Shafran, portfolio manager of Waddell & Reed Advisors Science & Technology Fund. Chai sees signs of the pickup in hardware sales and says that a software recovery tends to lag.

Computer companies in the S&P 500 are about 17% undervalued, and software outfits sell at an average discount of about 14%, according to Bloomberg’s consensus of analyst forecasts. Those same analysts predict shares of Dell (DELL) could rise 28% over the next 12 months and software company Compuware (CPWR) could see its stock rise 27%, to 10. Shafran particularly likes Microsoft (MSFT). “It used to be people bought their products because they had to,” he says. “Now [Microsoft products] are actually getting good reviews.” At 29, shares are about 22% below their 2007 peak.

EMERGING SPENDERS

Spending outside of the developed world will become even more crucial for tech companies. “China, Brazil, and India will drive the growth,” says Parower. He says about a third of his fund is in foreign companies, with 5% in Check Point Software Technologies (CHKP), an Israeli company that gets more than half of sales from outside the Americas. He also likes Amdocs (DOX), a European company that makes software for customer-relationship management and billing and gets about 25% of sales outside Europe and the U.S.

And if the global recovery stagnates? Morningstar analyst Toan Tran says to stick with quality: Apple (AAPL), Hewlett-Packard (HPQ), IBM (IBM), and yes, Microsoft. “If the U.S. economy doesn’t do well, none of these companies will go bankrupt because of it.”

Kalwarski is Numbers department editor at Bloomberg BusinessWeek.

By
Lewis Braham

The junk stock rally is officially over. Or so says John Gould, co-manager of the Cullen High Dividend Equity Fund (CHDEX). “Last year, the 363 stocks in the Standard & Poor’s 500 that pay dividends gained 26.2%, while nondividend payers gained 65.3%,” he says. “Low-quality companies with no dividends and no earnings outperformed—typical for a market recovering off extreme bear market lows. But we’re entering a new phase. The best performers in the last four months have been strong dividend payers.”

That Gould sees paying a dividend as a sign of corporate strength should come as no surprise to anyone familiar with market history. Since 1972 the average dividend-paying stock in the S&P 500-stock index has produced an 8.5% annualized total return. That compares with 1.2% for nondividend-paying stocks and 6.8% for the S&P 500 as a whole, according to Ned Davis Research. The outperformance was achieved with one-third less volatility than with nondividend payers.

Unfortunately, the average dividend yield for stocks is 2.2%—far from the 5.4% average yield stocks paid after the last great crash in 1974. But yields are likely to pick up. With bank accounts paying almost nothing and bonds little more than 3% or 4%, investors are hungry for income. What’s more, many companies that hoarded cash in the downturn are sitting on more than they know what to do with now. Cash as a percentage of total assets on corporate balance sheets was 12.5% at the end of 2009—the highest percentage on record. “Microsoft (MSFT) is sitting on $36 billion in cash,” says Gould. “What is it going to do with that? I’d be surprised if it didn’t announce another dividend increase before 2010 is over.” (Bloomberg’s dividend forecasting team, which uses seven factors to project future payouts, expects Microsoft to maintain its dividend this quarter and next, and to raise it to 14 cents per share, from 13 cents, in subsequent quarters in 2010.)

To play this trend, investors may want to consider a dividend-oriented mutual fund or exchange-traded fund. Managers of such funds generally employ one of three styles: equity-income, dividend growth and dividend capture.

Equity-income funds are usually the most conservative, seeking stable high current dividend yields. Allianz Dividend Value and American Century Equity Income (TWEIX) fall into this category. “We want companies to have sustainable dividends,” says American Century’s manager Phil Davidson. “We buy their stocks when they’re out of favor and their yields are above average vs. their history. But first we do a lot of work analyzing their balance sheets to make sure their dividends are sustainable.”

If Davidson is unsure about the sustainability of a company’s dividend but still thinks it is attractively valued, he may buy its convertible bonds instead, since those securities have more downside protection. (The bonds, which are convertible into the company’s stock, are senior to stocks in a company’s capital structure, and so have first dibs on the company’s income stream.) So though he owns common stock in steady Eddies such as AT&T (T), which has a 6.7% yield, he’d rather hold convertibles of the more fragile Bank of America (BAC) and U.S. Bancorp (USB). Davidson’s defensive strategy helped limit his losses during downturns. In 2008, American Century Equity Income lost 20.1%, vs. the market’s 37% slide, and its 7.9% 10-year annualized return beats 98% of its peers.

By contrast, a dividend growth manager such as Donald Kilbride of Vanguard Dividend Growth (VDIGX) cares less about current yield than the prospect for future dividend increases. “When I talk to investors, I try to get the conversation away from current yield,” he says. “I’m thinking about a stock’s future yield over the next five years.” So his fund has a lower 2.2% yield than Davidson’s 2.8%, although not much lower, thanks to Vanguard’s 0.32% expense ratio.

Kilbride argues that his strategy can be less risky than equity income funds since he is not chasing the highest yield. “A lot of the high-yielding stocks in 2008 were financial stocks,” he says. “We determined these were not dividend growers and that their underlying fundamentals couldn’t support their current payouts.” By avoiding banks and instead holding stalwarts such as shipper United Parcel Service (UPS), which has a moderate 3.3% yield but strong growth prospects, Vanguard Dividend Growth beat the broad market in 2008, falling 25%. It has beaten 95% of its peers in the past five years.

Clearly, the ideal balance would be to invest in companies with both high yields and strong growth prospects, and some funds try to do just that. Cullen High Dividend and TCW Dividend Focused combine these strategies but Cullen leans more toward equity income, TCW toward dividend growth. Other managers employ novel strategies to boost yields. The most common is called dividend capture. To “capture” as many dividends as possible, managers buy stocks right before their payouts and sell them soon afterwards, then move on to the next dividend stock.

TURNOVER TIMING

By using such a strategy, the Alpine Dynamic Dividend Fund (ADVDX) currently yields 17%. “We typically hold stocks for at least 61 days after they pay their dividends so the payout qualifies for the better dividend tax rate of 15%,” says Alpine co-manager Kevin Shacknofsky. “We also buy stocks of companies right before they’re about to make a special one-time dividend.”

Such a strategy has risks. For one, transaction costs are typically high as managers must trade stocks to capture the dividends. Alpine’s turnover ratio is 323%, more than 10 times that of Vanguard Dividend Growth. Also, such managers may have a tendency to chase stocks with the highest yields. Alpine’s yield-chasing burned it badly in 2008 as the fund fell 49%. Shacknofsky says he learned from the experience. He now holds a basket of more stable blue chips such as McDonald’s (MCD) and Johnson & Johnson (JNJ) in addition to his more aggressive plays.

Although high-yielding stocks with strong growth rates are rare in the U.S., they are far more common overseas, especially in emerging markets. “From 2002 through 2009, dividends in Asian stocks grew 18% per year on average, compared to just 6% for U.S. stocks,” says manager Jesper Madsen of the Matthews Asia Dividend Fund (MAPIX). “Throughout that period, the yield on Asian stocks was about half a percentage point higher than U.S. stocks.” Currently, he says, the average Asian stock yields 2.6%, or 3.1% if you exclude Japanese stocks.

Madsen’s strategy, like that of other dividend funds, held up better in the downturn. His fund fell 26% in 2008, while the average Asia Pacific fund dropped 43%. But unlike his U.S.-oriented peers, he outperformed during last year’s rally, gaining 47.6% while the average Asia fund returned only 34.7%. For dividend-hungry investors, his fund may be one where you can have your income and your growth, too.

Braham is a freelance writer in Brooklyn, N.Y.

By
Ben Steverman

If you talked to portfolio managers at any time in 2009, chances were good that they would extol the virtues of technology stocks. The information technology sector of the Standard & Poor’s index of 500 stocks rocketed 59% higher last year, beating every other sector and doubling the broad index’s 23.5% advance in 2009.

How quickly fashions change on Wall Street. A month into 2010, tech is down 8.2%, more than any sector but telecommunications, itself off 8.9% this year. The S&P 500 has dropped 2.3%.

The tech sector has lost steam despite good news on both the U.S. economy—such as a 5.7% rise in gross domestic product last quarter—and from technology companies themselves.

On Jan. 29, for example, tech heavyweight Microsoft (MSFT) reported earnings of 74¢ a share, 15¢ more than analyst predictions tallied by Bloomberg. Yet the results merely deepened Microsoft’s stock decline this year. After rising 57% in 2009, Microsoft shares in the new year have fallen 7%.

The tech selloff has been broad. The Nasdaq 100-stock index includes large-cap tech stocks such as Microsoft, along with Apple (AAPL), which is down 8.8% this year; Amazon.com (AMZN), down 13.9%; Qualcomm (QCOM), off 15.3%; and Google (GOOG), which has fallen 14.6% this year. Only 18 Nasdaq 100 members are in positive territory in 2010.

time to rebalance portfolios

Conversations with stock-fund managers suggest several reasons why tech stocks are having a tough year.

First come seasonal factors. In a new year, investors tend to rebalance their portfolios. After tech’s great run in 2009, it’s likely that many managers need to sell tech stocks to return their portfolios to their preferred sector allocation, notes Sean Kraus, chief investment officer at CitizensTrust.

Experienced traders have come to expect good results from tech companies late in the year, so they’re often ready to take profits early in the new year. “The smart money gets out, despite the good news,” says Kraus.

Another drag on tech stocks has been worries about growth, both in the U.S. and around the world—a factor that also has hurt the broader stock market.

Kevin Mahn, chief investment officer of SmartGrowth Funds, believes the economic recovery could disappoint many optimistic tech investors. In the U.S., the 10% unemployment rate will constrain consumer spending, which in turn will hurt business investment in new technology, Mahn says. “If people aren’t spending and businesses aren’t spending, how is technology going to lead the way?”

Worries that the Chinese economy is overheating have also hurt technology stocks because most tech companies are global businesses. To buy tech stocks, investors “need confidence that global growth is not going to slow,” Kraus says. Moves by China’s government to rein in GDP growth, which exceeded 10% in the most recent quarter, to keep inflation at bay have raised concerns among investors worldwide.

Tech: too popular, too fast?

A recent rally in the U.S.dollar is also posing a problem. A stronger dollar makes U.S. tech companies’ overseas profits appear smaller on income statements. The U.S. dollar index—measuring the greenback against a basket of foreign currencies—is up 6.6% since its 2009 low on Nov. 25.

The main reason for tech’s underperformance may just be that the sector grew too popular, too fast.

“People often get too excited about the prospects for tech,” says J. Stephen Lauck, chief executive of Ashfield Capital Partners, who nonetheless likes the sector’s long-term prospects. Tech outfits often feature greater innovation and faster growth than companies in other sectors and their stocks are also more volatile, prone to quick advances and rapid declines, he says. Investors know this, so they’re quick to take profits at signs of trouble.

Much of last year’s excitement about tech is still reflected in the sector’s valuations. According to Bloomberg data, the Nasdaq 100 has a price-to-earnings ratio of 21.57. That’s quite a rebound from the index’s P-E of 12.9 on Nov. 21, 2008. The S&P 500’s current P-E ratio is 18.5.

Faster growth expectations arguably justify tech’s pricier valuation. According to Bloomberg, analysts give the Nasdaq 100 earnings a long-term growth rate of 14.8%, compared to 9.7% for the S&P 500. Tech P-E ratios also match recent history: The Nasdaq 100’s average P-E over the last five years is 27—although the economy was much better in most of those years.

tech earnings expectations now lag

“You can buy many outstanding, market-leading tech companies for very little, if any, premium,” says Lauck.

Analysts have become more optimistic about tech in 2010, reflecting upbeat earnings results and better data on the economy. Here too, the sector has lagged the rest of the stock market. According to Bloomberg data, expectations for S&P 500 earnings growth this fiscal year have risen 25% in just the last four weeks while for the Nasdaq 100 index, expectations climbed 15.4%.

Despite recent setbacks, many investors remain enthusiastic about technology stocks—particularly their long-term prospects.

The sector is producing “a tremendous amount of innovation,” says Larry Rosenthal, president of Financial Planning Services in Washington, who sees this as a good buying opportunity for stocks in the category. “Tech is going to be a leader as the economy emerges [from recession] over the next three or four years,” he says.

Tech’s proponents frequently cite the prospect of increased demand from both consumers and businesses. Consumers may be short of cash, but spending on consumer technology held up surprisingly well last year, notes Peter Misek, global technology strategist at Canaccord Adams.

consumer demand fuels tech sales

Apple, a company very popular with consumers, saw sales rise 32% last quarter.

Peter Klein, Microsoft’s chief financial officer, said in a Bloomberg interview on Jan. 29 that consumer demand, not business demand, has driven the company’s recent strong results. “We are not seeing the enterprise recovery yet,” he said. “The timing of that recovery is uncertain.”

Many economists believe businesses are beginning to open their wallets. In a statement on Jan. 27, the Federal Reserve noted that “business spending on equipment and software appears to be picking up.”

Misek says there is pent-up demand for corporate tech spending. “As company earnings continue to accelerate, we think capital spending on technology is going to rise,” he says.

Tech stocks could face difficulty repeating 2009’s rapid advance in 2010. But many tech enthusiasts say they will be patient. “It might be a couple years out before you see a lot of momentum, but it’s something we’re willing to wait for,” says Chris Ambruster, vice-president of research at Al Frank Asset Management.

Steverman is a reporter for Bloomberg BusinessWeek’s Finance channel.