Funds Leery of the Chip Sector

Last year's rout continues to cast a shadow over the sector.
By Gregg Greenberg ,

While

Intel's

(INTC) - Get Report

strong midquarter update left semiconductor investors feeling chipper, fund managers remain leery in the wake of last year's thrashing.

Of course, Intel's upside surprise Thursday wasn't the industry's only recent good news. Strong earnings spurred Street upgrades for

Altera

(ALTR) - Get Report

and

Xilinx

(XLNX) - Get Report

, while

National Semiconductor

(NSM)

beat estimates by posting fat margins on its key analog products.

Moreover, many observers say the inventory glut that hammered the group last year is under control, and that should clear the way for these stocks to regain some altitude.

Even so, most fund managers say they are investing in the group by culling from favorite picks rather than casting a wide net across the sector. Some tech fans just can't get past that 2004 rout.

"Semis were awful last year, and a lot of optimistic people got burned," says James Morrow, portfolio manager for the chip-heavy $2.8 billion

(FSELX) - Get Report

Fidelity Select Electronics fund. "That's the basis for the skepticism you are seeing in today's market."

Last year was undeniably tough for the semi stocks. The Philadelphia Semiconductor Index, or SOX, fell 15%, while the

S&P 500

rose 11% and the tech-dominated

Nasdaq

was up 8.5%. Making it even tougher were high expectations for the sector after the incredible 70%-plus returns the SOX collected in 2003.

Sentiment turned especially bad last summer, when a string of downgrades hit the sector, mostly due to worries over rapidly rising inventories.

"You could definitely make the case that the chip manufacturers got ahead of themselves in 2003, which caused 2004's inventory problem," says Josh Spencer, tech research analyst for fund giant

T. Rowe Price

.

Recently, however, Wall Street's sell side has changed its tune on chips, contending that inventory problems have been corrected and margins, utilization rates and earnings growth are improving.

Valuations have also seemed to come into line in Wall Street's estimation. Earlier this month, for example, J.P. Morgan Chase joined a growing list of investment banks turning positive on the group by raising its rating to bullish from neutral. In his note, J.P. Morgan Chase analyst Christopher Danely wrote that "valuation appears to be reasonable, as most companies in our coverage universe are trading at roughly the midpoint of their ranges. We believe multiples will expand as bookings improve."

The sell side may believe the semi ship has righted itself, but buy-siders such as Zachary Shafran, portfolio manager for the $2.2 billion

(USTFX)

Waddell & Reed Advisors Science and Technology fund, are not running to get aboard -- at least until they see surer signs of improved end demand.

"A number of encouraging things are going on, but generally demand visibility is limited," says Shafran.

Likewise, Andy Sheridan, portfolio manager for the $100 million

(STNAX)

SunAmerica Focused Technology fund, says, "The inventory issues have been corrected, but we still lack visibility."

Even Danely doesn't seem overwhelmed by the demand picture, calling it "decent" in his report. As a result of this cloudiness, most fund managers say they are "picking their spots" and narrowing their selections instead of spreading their bets across the sector.

Shafran says the key nowadays is to be in the right product. He points to

Synaptics'

(SYNA) - Get Report

steep drop in February on rumors --

later debunked -- that

Apple

(AAPL) - Get Report

would be sourcing components for its iPod music players elsewhere.

Synaptics' troubles proved to be a boon for

Cypress Semiconductors

(CY) - Get Report

, whose stock jumped on news that it was getting cozier with Apple via a PowerBook deal that Synaptics did lose out on. The Synaptics snafu also bolstered the fortunes of Shafran, who chose Cypress as one of his favorite semi picks.

Sheridan is also basing his top chip pick,

Texas Instruments

(TXN) - Get Report

, on where he sees growth in end user demand. Sheridan says TI will be a big player in DLP, or digital light processing, TVs. He sees them setting the standard for the high-definition, thin-and-light TV market.

Peter Vanderlee, co-portfolio manager on the team of the $6 billion

(SHAPX) - Get Report

Smith Barney Appreciation fund, agrees there are "pockets of demand" in what he calls the "bifurcated world of semiconductors." But he says that investors need not outthink themselves too much looking for chip plays, when industry giant Intel is fairly attractive at its current $25 level.

Intel helped reassure backers like Vanderlee last week during its midquarter update, saying it expects to post quarterly sales between $9.2 billion and $9.4 billion and gross margins of around 57%. At the quarter's start, Intel projected sales of between $8.8 billion and $9.4 billion and gross margins of 55%.

"Intel doubled its dividend in November and now yields 1.3%," says Vanderlee. "This may be an admission that growth properties are not the same as they were five years ago, but then again, the world has changed significantly in favor of dividend stocks since the bubble."

T. Rowe's Spencer also likes Intel, saying its scale gives it advantages unrivaled by any other chip company. However, he says the best way to play the sector is to ignore "the upgrade-downgrade game of trying to time the cycle."

"The key is to own high-quality names across the chip cycle so you don't have to worry about demand problems," says Spencer. "The group is a lot less exciting than the hype around it."

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