K.C. Swanson

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Chip Stocks Leap Over Naysaying Analysts

K.C. Swanson

Chip stocks opened 2003 with a flurry, even as some of the investing world's heavyweights were taking jabs at the sector.

Thursday opened with two Wall Street banks issuing jaded predictions for early 2003. Merrill Lynch says it's shorting a basket of chip stocks, while Goldman Sachs warned of a falloff in tech spending. The comments, which focused in part on the weak economy and in part on the perceived priciness of semiconductor company shares, illustrate pundits' increasing wariness about the timing of any economic pickup.

Yet PC and semi stocks vaulted higher, with the benchmark index rising 6%. Bulls cited incremental signs of economic stabilization, like firming business investment and today's surprisingly strong manufacturing report from the Institute for Supply Management. And so the first day of 2003 proved a continuation of last year, when even a string of painful setbacks did little to stifle a long-running debate about the sector's prospects.

"In general, I'm optimistic at least about a lot of tech companies," says Paul McEntire, manager of the (TPFQX Quote - Cramer on TPFQX - Stock Picks)Marketocracy Technology Plus fund. "The main point being that a lot of them have been beaten up quite thoroughly over the last couple of years, and from what I hear in different sectors, excluding telecom, things are improving."

Wall Street seemed to agree Thursday, despite the cautionary comments early on. Among the big players, Intel(INTC Quote - Cramer on INTC - Stock Picks) soared $1.08, or 7%, to $16.65; IBM(IBM Quote - Cramer on IBM - Stock Picks) added $2.70, or 3%, to $80.20; and Hewlett-Packard(HPQ Quote - Cramer on HPQ - Stock Picks) gained 92 cents, or 5%, to $18.28.

Cruisin'

The runups came after Goldman Sachs warned that tech investors could be setting themselves up for a bruising if a rally kicks off early in the year. Analyst Laura Conigliaro argues that valuations and '03 estimates already look overblown.

She points out that the average tech company is trading at 1.8 times the P/E of the average S&P 500 company -- several notches above the pre-bubble high-end level of 1.4 times.

"Eager to rationalize premium tech valuations, investors are likely to turn the clock forward to 2004 estimates early in the year, much as they did last year with 2003 estimates," the analyst wrote. But she added that forthcoming '04 numbers will be built on 2003 estimates "that are, in our opinion, already erring on the side of optimism." She thinks investors are likely to see those hopes squashed later in the year, as reality begins to set in.

On the basis of similar valuation worries, Merrill Lynch said in a note it has decided to short Semiconductor HOLDRs (SMH Quote - Cramer on SMH - Stock Picks), a basket of 20 leading chip-related stocks, including names like Intel, Texas Instruments (TXN Quote - Cramer on TXN - Stock Picks) and Applied Materials (AMAT Quote - Cramer on AMAT - Stock Picks).

Merrill based the move mostly on an examination of trailing P/E and price-to-earnings growth ratios. The bank has underweighted the group by 20% in its technology index.

Penny Pinching

At the base of Conigliaro's bleary outlook is renewed concern about IT fundamentals. Tech managers now expect '03 spending to slide 1%, according to a new Goldman survey. That's a considerable turnaround in sentiment from a poll only two months ago, when respondents believed spending would rise 2% to 3%.

Also according to the survey, a worrying 43% of IT managers don't expect spending to accelerate until 2004 or later. A couple months ago, that figure was only 26%.

The upshot of all this: We could be in for a tiresome retread of '02. "If we are correct in our assumption of weaker-than-expected spending through 2003, we are likely to be faced with another long year of out-year estimates ratcheting downward as we draw closer," wrote Conigliaro.

Valuation Call?

The bulls understand that point but say there's value to be found sifting through the tech sector. Among McEntire's holdings are analog chipmaker Linear Technology(LLTC Quote - Cramer on LLTC - Stock Picks). Unlike semi outfits that rely heavily on the ailing PC market, McEntire says, Linear claims a broad customer base -- its silicon goes into everything from cell phones to automobiles -- that has helped it keep growing.

McEntire doesn't own any boxmaker names, citing intense competition in the industry, but he held onto chip-equipment maker Applied Materials through a bruising 2002. "I think its move into the submicron level and solid leadership position will put it in an excellent position perhaps in the third and fourth quarter," he says.

Memory producers are likely to drive some growth in the chip-equipment sector in 2003, predicts Manoj Nadkarni, founder of online investment newsletter Chipinvestor.com, pointing out that Samsung and Toshiba have already said they'll expand manufacturing capacity. The relative stabilization in memory price declines is somewhat encouraging for chip investors, says Nadkarni. "Memory prices always go up and down, up and down, but we're not seeing the kind of crashes that are typical of a major down-cycle," he says. Meanwhile, he says the semiconductor environment looks "kind of flattish."

Still, the bulls believe they're early, at least on some of the better growth stories. "Most of the people seem to think the more significant turnaround in their business won't occur for maybe another six months," McEntire continues. "But I think investors thinking longer term may do quite well by getting into companies right now, even if it takes a quarter or two before the turnaround comes."