Stock Screen: Time to play defense
By Lisa Meyer
Redherring.com, February 02, 2001
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No doubt investors need to be more discerning this year. As evidenced by the Nasdaq's plunge and the number of layoffs from dot-coms, thinking inside the new-economy box is no longer working. High-growth stocks with similarly high price-to-earnings ratios may not be the best way to make money in 2001.
And as investors continue to fear a recession, despite the Fed's recent interest-rate cuts, we think it's time to think defensively. Companies with cloudy near-term fundamentals in industries like personal computers and semiconductors may not have the sex appeal of an optical networking company. But many of the stocks are so cheap, it's as if investors are expecting them to stay out of favor for good. We believe that's a misguided notion, and we're not alone.
"One growing realization out there is that there is no such thing as a new economy," explains Arnold Berman, managing director and technology strategist at Wit Soundview. "The Internet is the greatest advance in communications since the telephone, which changed the economy. But that didn't mean that every company that was big before the telephone became irrelevant. The Internet will be used less to create a new economy than to grease the wheels of the old."
STOCKS THAT ARE CHEAPER THAN USUAL
With that in mind, we decided to screen this week for older technology companies that have been punished too severely in the last year. Using the Thomson Financial/Baseline stock analysis database, we searched for beaten-down stocks that possessed solid franchises. Such stocks might not be Wall Street's darlings now, but when the economy does take off again, these issues are likely to outperform the market.
To that end, we began the search with four technology industries: semiconductors, semiconductor equipment, electrical equipment, and computer hardware companies. Not only do analysts view these industries as defensive plays during economic downturns, all four are related to the PC and telecommunications sectors, which are recent victims of investors' concerns about slowing PC demand and an inventory backlog among carriers.
Next, to find companies that are cheaper than usual, we searched for stocks trading at trailing P/E ratios below their five-year averages. But of course, the future is important as well, so we made sure that the companies on our list had multiples lower than the S&P 500's average of 23 times 2001 earnings. We further whittled down the selection by choosing companies that are expected to post earnings growth in 2001 of at least 14 percent. (By comparison, estimated earnings growth for the S&P is just 6 percent.) Finally, we wanted to avoid tiny companies, so we set a market-capitalization minimum of $1.5 billion. Data as of January 31 was used to generate the screen.
Fourteen companies made it through the screening process: Amphenol (NYSE: APH), Atmel (Nasdaq: ATML), Compaq Computer (NYSE: CPQ), Integrated Device Technology (Nasdaq: IDTI), International Rectifier (NYSE: IRF), Kemet (NYSE: KEM), KLA-Tencor (Nasdaq: KLAC), Kyocera (NYSE: KYO), Lam Research (Nasdaq: LRCX), NCR (NYSE: NCR), National Semiconductor (NYSE: NSM), Philips Electronics (NYSE: PHG), Technitrol (NYSE: TNL), and Taiwan Semiconductor (NYSE: TSM).
The three that we decided to focus on were Compaq Computer, KLA-Tencor, and Lam Research.
COMPAQ COMEBACK
The market has gradually beaten down Compaq's stock during the last couple of years as it continued to undergo an often painful transition. The company has been shifting its focus from PCs to enterprise server and storage systems, and even though it has tough competition in these markets from players like Sun Microsystems (Nasdaq: SUNW) and EMC (NYSE: EMC), it looks like Compaq's strategy has paid off.
Robert Cihra, an analyst at ING Barings, says that Compaq is in a stronger position than other PC competitors like Dell Computer (Nasdaq: DELL), since 50 percent of its revenue comes from enterprise servers compared to less than 20 percent for Dell. "And enterprise revenues are steadier than corporate and consumer PC purchases," Mr. Cihra adds.
Compaq's strong international presence is another weapon that will help the company fight the U.S.'s economic downturn. According to Mr. Cihra, Compaq derives less than 50 percent of its sales from North America.
Although the slowing demand for personal computers has taken a toll on Compaq's earnings outlook for this year -- according to Thomson Financial/Baseline, estimates for Compaq's 2001 earnings have been revised downward 13 times during the last 30 days -- the stock is still trading at a much lower level than it usually does. Its trailing 12-month P/E ratio is 38 percent below its five-year average. Earnings are still expected to increase by 21 percent in 2001, even with the downward revisions, yet the stock is trading at only 20 times 2001 earnings estimates.
VALUES IN CHIP EQUIPMENT
The outlook for semiconductor equipment makers KLA-Tencor and Lam Research is even better, but these stocks have also been beaten down. Analysts expect earnings growth of 64 percent for KLA-Tencor in 2001 and 41 percent for Lam Research. Such growth, when compared to the companies' stock valuations, makes them attractive buys in our opinion. KLA is currently trading at 22 times its 2001 estimated earnings, while Lam sports a multiple of just 14 times 2001 estimates.
Both companies are influenced more by the semiconductor cycle than macroeconomic trends, says John Pitzer, an analyst at Credit Suisse First Boston. "Although the margins of these companies fluctuate, over time their margin profiles have only improved. Historically, KLA has had the highest growth margins in the industry, while Lam outperformed the last upturn as well as the last downturn, too."
But since the semiconductor industry is in the beginning stages of its current cyclical downturn, Mr. Pitzer says that the earnings estimates for these companies are still too high, and he expects Wall Street to punish them even more. While there could be more downside in the short term, we think the companies have fallen far enough already, especially when you consider that the stocks are trading well below their historical averages. KLA's trailing 12-month P/E ratio is 41 percent below its five-year average, while Lam is trading 68 percent below its five-year average.
So as the economy continues to slow, investors might want to consider having more older technology companies like these in their portfolio. While it's true that none of these stocks will pay off big in the short term, the valuations are so low that by the time the economy does pick up again, investors who buy now will see some upside as others rush back into these downtrodden sectors.
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