10 Questions With Sit Mutual Funds' Gene Sit

The skipper's Y2K1 outlook: health care rules first half, tech dominates second half.
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If growth investors are at a technology/health care crossroads, then Gene Sit might be a good crossing guard.

Last year, money fled the sagging tech sector for health care stocks, which lapped the market. Conventional wisdom says tech stocks will rise if the economy picks up again, but that health care stocks' secular growth will buoy them if the economy stays listless. This is a good time to talk to Sit, if only because his

no-load

(SISTX)

Sit Science & Technology fund invests in both tech and health care.

Long story short, he thinks health care will lead tech in the first half of the year, but sees a tech recovery in the second half as a healthier economy spurs demand for tech shops' products. If you're weighing the two sectors, you should hear what Sit has to say, if only because that's what he does for a living.

10 Questions With Eugene Sit

Fund: Sit Science & Technology

Assets: $44 million

3-Year Annualized Return/Ranking: 32.9%/Beats 58% of its peers

Expenses: No-load, 1.25% annual expense ratio.

Top-Three Holdings: Applied Micro Circuits
Checkpoint Systems
IDEC Pharmaceuticals

Source: Source: Morningstar

1. Let's start with tech stocks. In 1999 we saw outsize gains and last year we saw a meltdown. What do you see this year?

Sit:

Our view is that we've had the January effect

the boost stocks often get at the beginning of a year, and I think the fundamentals will drive stock prices now.

We think tech will do well, but it may be more of a second-half play than a first-half play. The reason being, you need the economy to stabilize. You need earnings comparisons for electronic tech to be easier. Remember, last year we had a very, very strong first half.

This year, tech spending will be relatively weak in the first half, and that will cut demand for some of these products. Likewise, we're going through the impact of a slowing in the economy in some of these stocks, be it

PMC-Sierra

(PMCS)

or

Applied Microcircuits

(AMCC)

and so on. This economic sensitivity is the reason

Cisco

(CSCO) - Get Report

said that, basically, their earnings visibility is not very good in the near term, because of the weaker economy at home, which is spilling over into the rest of the world. I think we need to go through that adjustment process.

The good news is that we think the outlook will be a lot better come Labor Day than it is today. I think that the market will start to anticipate that.

In the near term, and I'm talking about the next three-plus months, you could probably make more money in the pharmaceutical, biotech and in the health care services stocks than tech.

I would say come late spring we're probably going to be shifting more into the electronic tech area to benefit from the economy's sensitivity and probably more favorable valuation level. We did the reverse of that in the year 2000, when we cut back some of the tech services, and some of the electronic tech, and shifted over to the health care area.

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2. Health care led the market last year, so some think the sector might cool off. What do you see for health care stocks this year? Which industries look strongest and which look weakest?

Sit:

I think health care is going to do well, but the only thing is, they've already done so well. So we think you have to be very selective, you have to find those companies that have the potential for accelerating earnings from new products.

Find me the next Viagra, that's what I'm talking about. I guess in terms of pharmaceutical companies, we think

Eli Lilly

(LLY) - Get Report

has several major drugs on the pipeline, and we think that they have the potential for accelerating growth beyond the near term. We also like

Pfizer

(PFE) - Get Report

and

Merck

(MRK) - Get Report

. We just think that at current valuation that they're strong holds at this point in time.

In the biotech area we like

Amgen

(AMGN) - Get Report

because they have three or four major products in the development stage that could be blockbusters, and we think that their growth rate will accelerate in the low teens to the mid-20s in the next three to four years. If you asked me what's our favorite stock today, it probably would be Amgen.

If you asked me what's our second-favorite biotech company, I'd look at

Protein Design Lab

(PDLI) - Get Report

or

IDEC Pharmaceutical

(IDPH)

.

What in health care do you think is weakest?

It's a matter of price and fundamentals. Return potential will be based on the valuation and the fundamental outlook, and I would say maybe

Johnson & Johnson

(JNJ) - Get Report

and

Schering-Plough

(SGP)

are richly priced. There's nothing wrong with those companies; it's just that there is nothing exciting that the market is recognizing as favorable prospects.

And then we would question companies like

Guidant

(GDT)

, and some of those that have fundamental concerns right now.

3. What sleeves of tech look most and least attractive?

Sit:

I think the best area over the long term for secular growth is the entire electronic or information storage area and software companies related to that. Here,

EMC

(EMC)

is the big banana, then you go down to

Brocade

(BRCD)

,

Network Appliance

(NTAP) - Get Report

and

Veritas Software

(VRTS) - Get Report

.

As you see technology evolving, I think the second area would be the networking area with its ties to the Internet. From there you go into the specialty chip companies, telecom chip companies, that would be tied into the growth of the Internet, and the cellular phone is a part of that.

Within networking some are concerned about potentially risky practices like vendor financing, where companies are loaning money to their cash-strapped customers. You like the networkers, but does this concern you?

Sit:

I think enough time and exposure has been given this issue. I think it's priced into stocks like

Ciena

(CIEN) - Get Report

,

Juniper Networks

(JNPR) - Get Report

, Cisco Systems and even

Lucent Technologies

(LU)

.

What we need for those stocks to bottom out is maybe more time. Cisco is still struggling between $35-$40, and it's probably going to take until May to figure out how bad the third fiscal quarter is, but I think the vendor financing is a very minor part of it. Even though they write off a lot of it, you need to stay focused on each company's order rate.

The area that's probably the least attractive in tech, I would say, are the sectors that are PC-related.

4. That's interesting. PC sales are maturing, but a lot of these stocks like Apple (APPL) , Dell (DELL) - Get Report and Compaq (CPQ) are up more than 40% after a tough 2000, so some investors thought they were oversold. What sours you on them?

Sit:

In our tech fund and the tech portion of our other portfolios, we're emphasizing those companies with more open-ended upside opportunities. That means those companies that have high, sustainable growth rates that we think will continue after we buy them because of solid products and or competitive advantages.

As a tech investor, experience has taught me that you make money by A) paying high P/Es

price-to-earnings ratios, not low P/Es, because growth companies don't have low P/Es; and B) you've got to own companies with the strongest competitive positions; and C) you want to be in those sectors that have the strongest secular growth rates, like electronic storage, specialty chip companies and, I would also include, the Internet infrastructure areas like a

BEA

(BEAS)

or

Micromuse

(MUSE)

.

So, I would concentrate a tech portfolio in these three or four strong growth areas and the premier companies in those areas. I call these eating sardines because they're companies that you really want. You consume a little bit, take a little bit of profit, but you want to have them in your refrigerator.

After I've built positions in those stocks, I'd look at trading stocks or trading sardines. These are the PC-related areas. You've got to buy them at the right time; you've got to sell them at the right time. You may do well, but it's not how the big money is made.

5. Value fund managers have nibbled at some tech after last year's selloff. But it doesn't sound like you're a fan of bottom-fishing in the Nasdaq. Is there value there?

Sit:

Well the numbers will show that the valuation on the Nasdaq is about half of what it was 15 months ago. And relative to the market, it's also more favorable than that because the market has gone up while tech went down.

The market last year, excluding tech stocks, was actually up like 8%. And the

S&P 500 was down 9%, so basically it was the decline in tech that dragged the market down.

But the P/Es are still relatively high, and they should be higher because the growth rates are much stronger. Our take on this is that basically we think technology stocks are bottoming, we think Nasdaq is going to outperform the S&P this year. One part of me says the best time to be making money is when the

Fed is your friend.

In other words, when they're slashing rates.

Sit:

Right. On the other hand, I'd have to say to you, I don't know whether this economic recovery is going to be a V

marking a sharp rebound, I think it may be an L

a slowdown in the economy. We're on the downside right now, and we need a couple of quarters for this thing to stabilize. If it's an L, that means that there could be the third quarter before we come back.

So, I say, well, I'm going to buy at about Memorial Day. Tech stocks, that is.

6. What are investors missing today?

Sit:

I think what we're missing is fundamental research. I think you will find Wall Street to be more transaction-oriented than investment-oriented. As a result, analysts usually recommend those stocks that have a very strong, near-term outlook, and they will judge near-term outlook just in terms of how well the stock is doing in the marketplace, not the company itself.

And you know, that got us into a lot of trouble in the blowup in late 1999 when every stock was worth 100-200 times earnings,

Qualcomm

(QCOM) - Get Report

was going to go to $1,000 and every business model for the dot-com companies was valid. Now $200 billion have been lost in the last 18 months.

Analyst don't want to do any work in terms of figuring out an industry's prospects and which companies are best-positioned in terms of those secular trends.

Instead, it is focusing in the latest report and what management is saying. That's what we're missing, I think, a long-term orientation. There's an unwillingness to really understand industries and the companies involved. There's an unwillingness to be really truly analytical and recommend businesses, rather than just trying to play stocks on a short run.

7. Companies have been saying they're going to spend less on technology this year, and that's caused quite a stir. What tech industries will still get big orders from corporate customers?

Sit:

Certainly the Internet infrastructure, the network security solutions area with companies like

Checkpoint Systems

(CKP)

, the storage area, and then I've got to say the whole networking area.

I think you should keep in mind that we had a big acceleration in capital expenditure in tech area because of Y2K that started in 1999, continued at a very strong rate for the first half of last year. Companies had to make the investment to be competitive and in compliance and so forth. For the two years through the year 2000, technology capital spending was growing close to 40% year over year.

So now we're back to normal, and I think a more normal growth number may be closer to 10%-15%, but this year it maybe be closer to 5%. This implies a decline in the first half of the year and some recovery in the second half. But you've got to keep in mind that technology is a very, very important competitive element, and a productivity element.

It's also important to remember that about half of tech spending is people, not equipment.

8. A lot of investors own Microsoft (MSFT) - Get Report and AOL Time Warner (AOL) . They suffered through big losses last year, and they've seen big gains so far this year. What's your take on the two companies going forward?

Sit:

Of the two, I probably like AOL better because it's in the Internet information area, content as well as everything else.

It's basically an Internet service provider of a number of products and is the dominant company. There will be some economies of scale in the merger with Time Warner, but basically AOL will continue to be the dominant Internet service provider, and you can see how well-positioned it is, competitively, going forward.

In the case of Microsoft, they have the problem of big numbers, meaning it's hard for a giant company to keep growing. What do they do for an encore given the size of this company at this point in time? I think it's benefiting near term from the hope that they'll get a better deal at the

Justice Department

under the new administration.

So, I would say AOL's an eating sardine and Microsoft is a trading sardine.

9. A new trading metric is born. If you had to buy three stocks today and hold them for five years, which would you pick?

Sit:

I would buy Amgen, Checkpoint Systems and

JDS Uniphase

(JDSU)

.

You just see the strongest secular growth in those three companies?

Sit:

Quality companies. Buy and hold. Eating sardines.

10. What's the most recent new name added to your personal portfolio?

Sit:

Well, to be very honest with you, the insiders own about 20% of this fund.

That's great.

Sit:

My family owns half of that, so I've got 10% of the fund and I've been buying it for my own account.

Fund Junkie runs every Monday, Wednesday and Friday, as well as occasional dispatches. Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.