Tech Companies Rebounding

OCEAN CITY — It should come as little surprise that earnings reports from major technology companies have been driving the strong market news of late. Investing in today’s tech sector is considerably different from the dot-com bubble (and bust) that eliminated $5 trillion in shareholder value back in the early 2000s. Currently, many major tech companies boast solid balance sheets, strong business fundamentals and attractive valuations.

Larger, slower-growing technology firms are especially appealing, says David Bianco, head of U.S. Equity Strategy at BofA Merrill Lynch Global Research. "Many of these companies are being priced as if they’re likely to gradually go out of business, and that’s preposterous," he says. "In fact, these are great businesses, in my opinion — their earnings have only gotten stronger over the past few years, and I believe many of them are poised to capitalize on expanding demand from emerging markets and a global recovery in business spending."

True, no sector is without risk. Case in point: Semiconductor shares tumbled in mid-March, in response to the closure of Japanese chip makers following the catastrophic earthquake and tsunami. However, from a market point of view, this may prove to be a temporary obstacle: Many factories have already restarted production and shipping, and Japanese companies seem committed to maintaining the international competitiveness of their electronic component industry. In the meantime, a number of catalysts should drive strong results for technology companies in the year ahead.

Perhaps the most important factor to consider when assessing the outlook for the tech sector is growth outside the United States, largely in emerging economies, particularly China. Bianco notes that while S&P 500 companies have been generating about 40% of their profits outside the U.S., he expects that figure to climb to 50% in just five years. Technology companies as a group have significant exposure to foreign markets, and in particular to the emerging markets expected to provide the lion’s share of the world’s economic expansion.

Meanwhile, consumers worldwide are demanding access to broadband and mobile Internet. "They want the ability to access information no matter where they are," says Tal Liani, a research analyst at BofA Merrill Lynch Global Research. "That boosts demand for new devices, bandwidth, software and other technology products."

Consumer demand is only part of the story, one that is dwarfed by the expected rise in business capital spending. During the economic downturn, companies invested in technology only to the extent that they had to. But today corporations are entering the recovery with historically large cash stakes and little debt; as concerns of a double-dip recession wane, corporate decision makers are likely to begin spending in earnest.

At the same time, corporations are moving rapidly to take advantage of the efficiencies of cloud computing — the ability to cut costs and optimize network capacity by using servers deployed in different locations, rather than adding capacity in any single one. That requires major investments in networks, software, storage and other components — creating demand for companies that build the cloud’s infrastructure.

What’s more, many companies increasingly prefer to do business with one tech provider worldwide — and the sector’s largest companies are positioned to benefit from that trend. "As a result, large-cap tech companies may try to crowd out small local players," says Bianco, "and acquire them at reasonable terms."

Despite the sector’s current strong fundamentals, tech has been neglected by many conservative investors who eschewed any asset considered risky.

"The only people who put money into tech in the past few years tended to be dedicated tech investors," Bianco says. "And even they often put all their firepower into the growth stars. We like those stocks too, but we think companies offering steadier if less spectacular growth have been neglected. We believe the best opportunities are on the value side of large-cap tech."

Bianco points out that in February 2011, shares of the Tech Titans were sporting an average price-to-earnings ratio of just 13 — the lowest since 1995 — despite a benign interest-rate environment, very strong balance sheets (the companies have cash equal to 15% of their market capitalizations) and the firms’ dominance of a fast-growing global market.

"These companies are the technology sector," notes Bianco, who points out that these corporations combined account for about 85% of the sector’s profits. "Their profit-to-earnings ratios shouldn’t be 13 or 14. We think they should be more like 15 or 16, and that valuations should expand from there."

With that in mind, Bianco recently increased his recommended tech allocation to 22% — three percentage points higher than the sector’s weighting in the S&P 500. As he puts it: "I believe these are some of the best-positioned firms in the global marketplace."

(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)