Don't Buy the Tech Hype
Buying solid, cheap tech firms is a better bet than chasing after the next big thing.
Stock Strategist
Apple (AAPL) (and the rest of the tech industry for that matter) has a way of building up hype. Despite prototypes of the of the firm's iPhone 4 leaking out, there was still enormous anticipation as Steve Jobs took the stage at Apple's developers' conference to officially introduce the new smartphone.
From the mainframe era to the early dot-com craze to today, the industry has been expert in hyping its products and informing us how they are going to change our lives. The buzz surrounding the emerging tablet market among others has led tech, on both the software and hardware side, to be one of the few sectors that is still talked about as a growth story in this economy.
Certainly the prospects of growth are better in the tech industry than in many other places in the economy, but have investors gotten ahead of themselves? Our team of equity analysts thinks yes. Software and hardware are the only two sectors that our equity analysts think are still overvalued, commanding an 8% and 6% premium to our estimation of fair value.
Sector Price to Fair Value Software 1.08 Hardware 1.06 Consumer Services 0.99 Consumer Goods 0.97 Media 0.95 Telecommunications 0.91 Financial Services 0.91 Energy 0.91 Business Services 0.89 Health Care 0.85
The most overvalued names are currently companies that operate in areas of the tech market that are some of the most hyped and talked about at the moment--software as a service, health-care IT, and virtualization.
It's not that these aren't areas that are likely to do very well during the coming years; it is that the stock prices have outpaced the potential growth. Here are a few of the most overvalued names.
Cerner
Economic Moat: None | Fair Value Uncertainty: Medium
From the Premium Analyst Report:
We believe Cerner will continue to benefit from the opportunities presented by the U.S. health-care system. The company has capitalized on the urgent need to streamline the system's inner workings and lower operating costs. From its roots as a provider of laboratory information systems, Cerner has evolved into an integrated provider of IT solutions that support all the venues of the health-care realm. However, the complex legal framework that regulates the health-care industry and privacy concerns related to the use of electronic medical records could hamper Cerner.
VMWare
Economic Moat: Narrow | Fair Value Uncertainty: High
From the Premium Analyst Report:
VMware's success has the IT world focused on virtualization in corporate data centers. Management has laid out its vision to capture the next phase of growth, but we are skeptical that VMware will be able to repeat the dominance it achieved with server virtualization.
Red Hat
Economic Moat: None | Fair Value Uncertainty: Medium
From the Premium Analyst Report:
Red Hat makes money giving away free software. However, without an economic moat, increased competition threatens to slow Red Hat's impressive growth. The open-source software model leaves Red Hat vulnerable to changes in customer preferences. Open-source software is free for anyone to use and may be distributed and modified at will. Therefore, Red Hat does not own the software it distributes, and any enhancements made by Red Hat are shared with competitors. This leaves Red Hat without a defensible economic moat because the firm's clients have a right to continue using the software even if they switch support vendors.
Tech Support for Your Portfolio
But not all tech stocks are overvalued right now. In fact, nearly 60% are currently rated 3 stars, meaning our analysts think they are roughly fairly priced right now. There are even a number of firms trading in 4- or 5-star territory. Many of these cheaper companies are in less hyped but still profitable parts of the tech world such as networking equipment and semiconductor suppliers. The list even includes stalwarts such as Microsoft (MSFT) and Hewlett-Packard (HPQ), which are both trading in 4-star territory. You can see the entire list of 4- and 5-star rated software and hardware firms by clicking here to use our Premium Stock Screener.
Here are a few of the highly rated firms.
KLA-Tencor (KLAC)
Economic Moat: Wide | Fair Value Uncertainty: Medium
From the Premium Analyst Report:
KLA-Tencor occupies a sweet spot in the chip-equipment industry because of its dominant position in the process diagnostic and control market. Chipmakers use PDC tools to measure and detect defects during semiconductor production and to identify and correct the problem sources; this lowers costs by reducing the number of faulty chips produced. Customers rely on KLA's tools to accelerate manufacturing to full production of new chip designs and factory startups, as well as to maintain high yields for devices already in production to maximize profitability.
ATMI
Economic Moat: Narrow | Fair Value Uncertainty: Medium
From the Premium Analyst Report:
ATMI is a top supplier of materials used during chip fabrication and will benefit from continued advances in semiconductor technologies. The firm has been seeing a rebound in business conditions after a tough 2009.
Demand is driven by the number of wafer starts (the number of silicon wafers placed into production) in the semiconductor industry, as ATMI's materials (such as gases, liquids, and various chemicals) are consumed during manufacturing. Therefore, ATMI's business is much steadier than those of chip equipment suppliers, which depend on chipmakers' volatile capital spending. Since the firm disposed of the last of its noncore chip equipment business in 2004 and focused solely on consumables, profitability has improved substantially. Moreover, because the material business is not particularly capital-intensive and operating margins of 20%-plus are achievable, we think ATMI's returns on invested capital can increase to the high teens in the long run.
Why Overpay?
When it comes to tech, don't buy the hype. There may be great companies with great futures ahead of them out there, but paying too much isn't going to do your portfolio any good. Buying solid companies at a discount to their intrinsic value should provide you with a strong enough long-term return to be able to afford all the shiny gadgets the tech industry hype machine keeps pumping out.
All data as of 6/7/2010