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Hot Sectors to Hedge Your High-Tech Bets

I tried, I really did. But I couldn't get a single nontechnology stock into the Future 50 stocks. The one nontech stock that I nominated to fill one of the six open slots on the list -- retailer Target (TGT) -- garnered a rather pathetic 6% when followers of this column cast their ballots. It finished ninth out of a list of 10 nominees. In fact, only two nontechnology stocks, Target and Mexican cement-maker Cemex (CX), made the list of 36 semifinalists. (For more on the nominees and the vote, see my July 21 column, Help Jim Pick Six For His 'Fantastic 50.)

And it wasn't just that my voters ignored nontechnology stocks. They scorned them. The inclusion of Target got comments such as "Target? Where's the growth there?" and "That is the sorriest bunch of nominations I've ever seen. Target, the department store, is going to outperform Nortel Networks (NT) or Applied Micro Circuits (AMCC) over the next five years? Are you kidding me?"

I find this both surprising and intriguing.

Still Swinging for the Fences

Surprising, because I would have thought that, given how badly many fast-growth, high-price-to-earnings stocks have been punished since March -- including examples in Jubak's Picks -- more investors would have voted for slower growth with less risk. I wouldn't have been surprised if the vote had shown a massive shift away from high-risk and high-tech. But despite the punishment, it seems like a lot of us are still swinging for the fences. Target, which analysts project will increase earnings by 16% in the fiscal year that ends next January, is just not as attractive a proposition to us as Applied Micro Circuits, which analysts expect to grow earnings by 133% in the fiscal year that ends in March 2001. And that's even though Target trades at a trailing 12-month price-to-earnings ratio of just 22, while Applied Micro Circuits trades at a multiple of 383.

Intriguing, because I think this reaction bodes well for a fall recovery in many of the highfliers that have taken a pounding this summer. Investors are likely to be somewhat more cautious, asking for real earnings and plausible plans to ramp growth. But it appears from this vote that the core of technology investors, whose support is critical for this group in the future, aren't about to abandon potential winning stocks from the revolutions in wireless communications, optical networking and electronic commerce that are reshaping the economy. The fundamental belief in those trends appears unshaken, and these investors appear willing to pay up to be part of those trends.

Good News for Tech Sector

That's an important indictor to me. Add in the record river of cash that flowed into stock mutual funds in the second quarter -- at $73.4 billion, the highest ever for the period -- and sentiment seems positive to me for the rest of the year. Fundamentals point the same way. Analysts are forecasting earnings-per-share growth of 10% or more for the rest of 2000, and we're about to enter what is traditionally the strongest part of the year for technology revenues and earnings. All in all, I think the battered technology sector is positioned to do much, much better in the last three to four months of the year.

That's good news for Jubak's Picks. My entire strategy this year has been built on sticking it out with many of the high-growth, high-multiple stocks in the portfolio until the fall -- and even adding a few names like BroadVision (BVSN) and Atmel (ATML). This will work out quite well for me if these stocks come roaring back the way they did in this same period in 1999. If everything works out, stocks like RF Micro Devices (RFMD) and PMC-Sierra (PMCS) will leave the slower-growing Targets of the stock market in the dust.

If this scenario is correct, I think it's pretty clear what an investor ought to be doing. Hold onto those high-growth, high-multiple technology stocks that have shown good relative strength during the technology crunch. Add new positions from among the technology stocks with the best relative strength, using cash raised by selling stocks that didn't come through the downturn in very good shape. (If you'd like to see a more detailed explanation of this strategy, see Jon Markman's Aug. 2 column, Stick With Strength to Beat August Heat.) I don't think you need to rush right out to apply this strategy -- August and possibly September are likely to have a few nasty surprises still in store for us. In fact, I think it's a good time to use some stop-loss orders. Over the next month or so, however, I'll be gradually implementing this strategy.

But that said, I also think it's important to understand that just because I want this to happen (and very badly, indeed) -- and just because I believe it will happen -- doesn't mean that it has to happen. While I think a late September rally that extends for the rest of 2000 is the most likely market scenario, it's not the only possible outcome. And anyone who invests as if it is takes a high-risk gamble. So even though I think it makes sense to build a portfolio on this favorable scenario for technology stocks, I also think it makes sense to plan for a future that's unfavorable for those stocks.

Which brings me back to where I started -- with the scorn heaped on my nomination of Target.

Let me connect the two problems -- macro market call and micro stock pick -- this way. I think it's true that Applied Micro Circuits will outperform Target if everything goes right at both companies. Similarly, a portfolio loaded with high-growth, high-multiple technology stocks will outperform one that more closely mirrors the S&P 500 -- if everything goes right for the technology sector over the next six months. The difference is that it is much more likely that something material will go wrong for Applied Micro Circuits than for Target, simply because it is harder to increase earnings at 133% than it is to increase earnings at 16%. (Similarly, I think there's a lot more that can go wrong with the technology sector than with the broader market.)

Fine-Tune Your Side Bets

It's hard to figure this "probability of error" into investment decisions. Most of us deal with this issue by a seat-of-the-pants method that we call hedging our bets. To a portfolio of high-growth, high-multiple technology stocks, we'll add a drip of retailers, a drop of financials, a dab of drugs. These sectors have tended to do well in the past when technology stocks have done badly.

We can fine-tune this sector selection by studying the recent performance of the market. In the last week or so, for example, when technology stocks have been down, sectors such as regional banks, drugs and oil drilling and services have been up.

And comparing a stock's (or a portfolio's) performance in an up market with its performance in a down market is also a useful tool. But I'd like to suggest a way to take this hedging strategy a step further by using a rough what-could-go-wrong analysis to see which sectors actually work best as hedges on a technology-heavy portfolio.

Here's What Could Go Wrong

OK, so what could go wrong with the technology sector? Let's take two major possibilities. Interest rates could resume their climb after the November election. And the economy could slow enough to hurt earnings.

How do those alternate scenarios play out with the sectors we're considering as hedges? Higher interest rates wouldn't be good for any stocks, of course, but they'd be particularly tough on financials. Slow growth in the economy, on the other hand, would probably help financials, since it would mean no more interest-rate hikes. I'd give financials a rating of minus one, plus one.

Drugs? Higher interest rates would probably work to the sector's benefit -- as long as the hikes weren't too aggressive -- since investors tend to buy drug stocks as safe havens when the market as a whole gets rocky. If economic growth slows, but again, not too much, the sector could go either way. Traditionally, drug stocks are a haven when growth comes into question. But the drug stocks are so high-priced themselves -- and Pfizer (PFE) recently threw a scare into the sector by posting anemic growth -- that slower growth in the economy is likely to hurt the sector. I'd give drugs a plus one, minus one.

Oil? Higher interest rates are not an issue, except for the most leveraged of companies. Slower growth? Not an issue either, as long as we're not talking recession. The price of a barrel of oil is high enough that it could fall substantially without forcing any cutbacks in drilling and exploration schedules. I'd give drilling and services stocks a plus two.

So to hedge a technology-heavy portfolio now, my first choice would be oil drilling and service stocks. I dropped Schlumberger (SLB) from Jubak's Picks on July 28 in the belief that we were far enough along in the recovery cycle for this sector to pick a more aggressive stock than this industry leader. My two picks at this point in the cycle would be Ensco International (ESV) and Marine Drilling (MRL). Both are highly leveraged to activity in the Gulf of Mexico, an area that has gone from cold to hot in recent months. I think the potential return from either of these picks is about 35% in a year -- Schlumberger by my calculations was likely to return 15%. Since I've only got one empty slot in Jubak's Picks right now, I'm going to add Marine Drilling, with a target price of 34 in August 2001.

My second choice as a hedge would be financial stocks, especially since I think there's a good likelihood that the Federal Reserve federalreserve will not raise rates this month. My picks here would be Golden State Bancorp (GSB) and Providian Financial (PVN). I'll write more about those and other financial stocks later in the month when I've got a slot for another hedging stock in Jubak's Picks.

Over the next month or so, then, I'll be looking to buy two different kinds of stocks. As in this column, I'll be looking for stocks with strong profit potential that are also a hedge in case the technology sector doesn't behave as I think it will in the fall. And, as in my next column, I'll be looking for the strongest technology stocks -- and weeding out the weakest in Jubak's Picks -- so that I can get the maximum return if technology stocks do rally. Those are two very different kinds of stocks, but all as part of a single strategy.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Atmel, Cisco Systems, and Puma Technology. He welcomes your feedback at mctsc@microsoft.com.

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