3 Tech Picks for the Patient

• In aggregate, the technology sector is slightly overvalued, and global telecom is fairly valued. A few areas present long-term value, notably in international telecom.
• The analytics market is growing, but regardless of its speed, size, or location, data is useless until it can drive actionable results. 
• Revenue for Internet companies with economic moats backed by unique customer data is likely to outpace the digital advertising market, but investors should demand a margin of safety.
• Mergers, acquisitions, and yield-seeking continue to push U.S. telecom stocks above fair value, in our view, but opportunities are still plentiful in Europe and Asia.

We have considered the technology sector to be either fairly valued or slightly overvalued for the better part of the past 18 months, whereas the communication-services sector has, until only recently, been considered undervalued. However, within each subsector, there are pockets of value for patient investors. In particular, we believe that the international telecom and domestic cell tower industries offer more appealing valuations. In the table below, we highlight a few of our top picks, including two from the telecom sector.

Taking a step back, with the tech and communications sectors trading at or above fair value, we would prefer a wider margin of safety and are quick to gravitate toward firms with established economic moats, which might be in a better relative position to withstand near-term revenue and operating margin volatility.

Big Data has become a household phrase, as the quantity of data has exploded as a result of new sources such as machine data, quantifiable sensors, blogs, and Web applications. We continue to believe that this global secular theme will play out, with new software technologies, cheaper memory, and cheaper processing allowing for broader application of statistical models to drive decision-making. We view this evolution as necessary, since "old" technologies (such as traditional data warehousing) are not able to tackle many of these new opportunities in cost-effective ways. However, despite this innovation, legacy systems for organizing and analyzing operational data are unlikely to be replaced. This is not a winner-take-all scenario, and instead we see many of the entrenched tech conglomerates actively investing in their own leading-edge products and services to drive switching costs higher and generate incremental revenue.

Advertisers' appetites for measurability and quantification of advertising effectiveness will lead to a rapid expansion in programmatic advertising sold by algorithms instead of salespeople. As Internet companies pursue growth, we expect increased M&A activity and geographical expansion, particularly beyond the mature markets of the United States and the United Kingdom. Companies will invest heavily in optimizing their advertising products and content for mobile devices.

The success and growth of  Google (GOOG) contrasted with the anemic revenue growth of former Web darling  Yahoo reveals two key requirements by digital advertisers: accountability and measurability. We believe an increasing amount of display advertising will be sold programmatically, reinforcing what we believe to be key assets in forming or protecting an economic moat. First of all, companies that have unique customer insights will be able to sell more advertising, in our view. Secondly, firms that can provide superior execution and liquidity for programmatic advertising will see solid growth, although, the sustainability of this growth is not likely to be obvious or defensible. The Internet market is maturing in developed markets because of increased broadband and smartphone penetration as well as advanced digital advertising markets. We expect companies to look beyond the U.S. and U.K. for growth, both organically and inorganically.

The U.S. telecom industry is at a unique point in history, with consolidation, regulatory policy, and technology converging in a manner that could fuel fireworks over the summer. We believe that some proposed acquisitions have had a ripple effect and are forcing regulators to consider the implications of significantly greater media consolidation. At the same time, the debate surrounding the "open Internet" or "Net neutrality" have taken on greater importance in the public sphere with consolidation on the horizon. As these issues are debated in Congress and the court of public opinion, there is a risk that the Federal Communications Commission or the Justice Department puts a hold on consolidation.

Consolidation is also occurring in Europe, cross-border.  Vodafone (VOD) is in the process of acquiring the largest cable operator in Spain, while the largest cable operator in France is looking to acquire the country's second-largest phone company. Meanwhile, all eyes are on the proposed merger of Telefonica Deutschland and  KPN's (KPN) German subsidiary E-Plus. If regulators approve this deal without too many restrictions, we think additional mergers could occur. Despite the M&A activity, which has particularly pushed up the prices of pay-television operators, there are still pockets of value across the global telecom space. Most come with baggage, either from lagging sales growth or higher legacy costs, so we encourage investors to be highly selective.

Top Tech & Telecom Sector Picks
	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Consider Buying
Crown Castle International		$90.00	Narrow	Medium	$63.00
Altera		$41.00	Narrow	Medium	$28.70
Orange		$21.00	Narrow	High	$12.60
Data as of 6-23-2014

 Crown Castle International (CCI)
Crown Castle is the second-largest independent operator of wireless tower communication sites in the United States and has carved out a narrow economic moat. The company owns roughly 40,000 tower sites in the U.S. and more than 1,700 in Australia. Crown Castle is poised to produce solid economic profits over an extended period as the firm benefits from secular growth in data usage in the ongoing increase in smartphone adoption. We believe these factors are underappreciated by the market, making the stock look undervalued.

 Altera
Altera forms half of the near-duopoly in the programmable logic device, or PLD, segment of the semiconductor industry and has a narrow moat, in our view. Although PLDs accounted for only $4.5 billion of the roughly $300 billion total semiconductor market in 2013, according to research firm Gartner, the segment has emerged with one of the industry's more interesting business models. We estimate that the PLD segment is poised to grow at roughly 1.5-2 times faster than the overall chip industry, since the economics of Moore's Law will encourage electronics makers to increasingly use PLDs. We believe the stock is attractively valued and will benefit from a couple of catalysts in the next few years: 1) a cyclical upturn in the PLD segment after a slowdown in the past couple of years and 2) the opportunity for market share gains from  Xilinx beginning in late 2015.

 Orange (ORAN)
Orange in the largest telecom operator in France (and still has a narrow moat) but has struggled since Iliad entered the wireless telephone market at the beginning of 2012, causing a giant price war. The market is now calming down, and while we expect revenue to continue to decline for several years, we anticipate the rate of decline will reduce. Importantly, France accounts for only about half of the firm's revenue and EBITDA. The company also has significant operations in Spain, Poland, and operates in 18 countries in the Middle East or Africa, which are some of the fastest-growing countries in the world. We don't think these operations are fully appreciated by the market. We project that with the lower revenue declines in France and growth in its emerging-market portfolio that Orange can return to revenue growth by 2017.

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