It's a tough time to be the CEO of a high-tech company. Just ask Carly Fiorina, who headed

Hewlett-Packard

(HPQ) - Get Report

until she was forced out by an unhappy board of directors last week. (Of course, her severance package of $21 million must take some of the sting out of her ouster.)

The problems aren't limited to H-P. Throughout the technology sector, you can find the same circumstances that challenged H-P. Fierce competition has crushed profit margins, not just for H-P's troubled PC business but for companies that sell servers, storage networks (and networked storage), and flash and plain ol' DRAM memory. Any pockets with high-profit margins, such as H-P's printer business, draw competitors like flies.

Abundant capacity, whether the task is turning silicon into chips or assembling routers, makes it easy for any upstart with cash in its pockets to break into the game. For all too many technology companies, this is a time when it's easy to sell more units but hard to make money on each sale.

And that makes this a very hard time to be a technology investor.

Cisco Systems

(CSCO) - Get Report

is an example. I'd argue that this company has done just about everything right in the last couple of years, but forget that its stock, which peaked at $76 in 2000, hasn't been able to approach that neighborhood in the years since the technology bubble burst. That's old, if painful, history.

Instead, look at how the sector's doldrums have left the stock becalmed recently. For over a year, Cisco's shares have been stuck in a range between $17 and $26. After announcing disappointing revenue and earnings numbers on Feb. 8, the stock dropped 2% and headed back toward the bottom of that range, closing at $17.63 a day later.

Two Tech Strategies

So what's a technology investor -- indeed, any investor looking to make a profit from stocks -- to do? I think there are two strategies that will work during the current technology troubles.

  • First, you can recognize that many technology stocks are stuck in a trading range and become a range trader, buying the stock near the bottom of the range and taking your profits at the top.
  • Second, you can look for the very few technology companies that have escaped the current margin squeeze because of the nature of the specific market in which they operate.

There is, of course, no reason not to combine the two strategies. In this column, I'm going to give you six technology names that you can use to profit from either -- or both -- of these strategies.

It's easy to understand why the stock of a company like H-P is going nowhere. Here's a company that sold $24.6 billion worth of PCs in the fiscal year that ended in October 2004 but earned just $200 million on those sales. That's a 0.8% profit. Results in the business-storage and server business weren't much better: $15.2 billion in sales and $200 million in earnings.

Trouble Below the Surface

But why is the stock of a company that is doing everything right, like Cisco, going nowhere? This specific case tells us a lot about what's keeping technology stocks down right now.

On the surface, the company's prospects would appear rosy. When the company released its earnings recently,

The Wall Street Journal

beamed, "Cisco's Net Surges on New Products." But problems quickly crop up when you probe the numbers.

Net income for the quarter that ended Jan. 29 climbed to 21 cents a share from 10 cents a share in the same quarter a year before, the story reported. That comparison looks spectacular with a 93% jump -- except, the

Journal

noted, that last year's earnings included a huge $567 million expense for stock options. Remove that and earnings climbed to $1.4 billion from $1.28 billion. A respectable, but no longer spectacular, 9%.

If that 9% earnings growth is the long-term trend for the company, it's hard to argue that the stock should be priced higher than it is now. The shares trade at about 23.4 times trailing 12-month earnings per share. That seems about right: Earnings for the

Standard & Poor's 500

are growing at a little less than that rate right now, and the price-to-earnings ratio, at 23.1 for the index, is also slightly lower than the price-to-earnings ratio for Cisco.

Cisco's Future Growth

Of course, you can spin a better story about Cisco's future growth. Sales of its voice over internet protocol (VoIP) equipment and Linksys home-networking gear grew by 40% in the recent quarter. With just about everyone agreeing that VoIP is the future for telephone equipment and with just about everyone also agreeing that Cisco is the leader in that market, you can certainly understand if investors occasionally decide that Cisco, at $17-$18 a share, is cheap given its potential growth.

But whenever those investors start pushing the stock back toward the $26 price that has marked the high over the last year or two, well-founded worries combine to smack the shares back down. For example, while in this quarter revenue climbed 12% to $6.06 billion from $5.4 billion, gross margins fell to 66.9% from 68.5%. On its earnings conference call, the company said it expects higher operating expenses in the current quarter, too. Cisco may be selling more stuff, but thanks to higher costs, it's making less profit on those sales.

The company was adamant that it didn't see the margins for any of its products fall. In other words, Cisco is keeping gross product margins intact despite competition from low-cost Asian producers; higher corporate costs are responsible for driving down gross margins.

But all the same, the sales picture isn't as bright for the company's flagship network switches. In the just-concluded quarter, sales for these switches fell 6% from the prior quarter.

When the company tells Wall Street analysts to expect revenue to climb 8% to 10% in the current quarter, below the Wall Street consensus projection, investors shouldn't expect the company's stock to rally.

Why Earnings Growth Is Low

Earnings growth for the best companies in the technology sector is both lower than it has been in the past and more uncertain. Until it's clear to investors that growth at a technology-sector star such as Cisco is going to be predictably and consistently higher than it has been in recent quarters, it will be hard for stocks in the sector to break out of their trading ranges.

I think there are three major reasons why earnings growth in the sector is low and why any projections of higher growth are worryingly uncertain right now.

  • Excess manufacturing capacity and cheap capital make it easy for hungry competitors to go on the attack whenever they scent excess profits. Selling printers isn't an especially profitable business, but selling ink cartridges is. It costs H-P about $3 to make a cartridge that sells for $35. Because companies build market share in the ink-cartridge business by selling more printers, is it any wonder that those such as Dell (DELL) - Get Report have targeted the business? Dell doesn't even have to go into the printer-manufacturing business: Partners like Lexmark (LXK) are happy for the chance to build printers for Dell to sell. The excess-capacity problem in the technology sector is made worse because so many technology companies use contract manufacturers to actually build their products.
  • Technology stocks may have lost their momentum, but technology innovation hasn't. Sure, it may be true that there's no Big New Thing to drive the sector, but all that's done is focus innovation on changes that pack more functions on a single chip, that reduce the size of components and that store more data in less space. The effect of innovations like these is to drive down the cost of products -- at a time when Reason No. 1 makes sure that the cost savings don't go to companies, but to their customers -- and to make even the most entrenched business vulnerable. Intel (INTC) - Get Report packs graphic processing onto its chipset, and Nvidia (NVDA) - Get Report feels the pressure at the lower end. Texas Instruments (TXN) - Get Report crams more of the functions of a wireless phone into its chips, and the effects ripple out through the entire industry. But it's not just the little guys who are feeling the pressure: A new chip, developed by a partnership headed by IBM (IBM) - Get Report, is taking direct aim at Intel's plans to make money from processing graphics and media.
  • Some technology companies have reacted to this competitive pressure by deciding that they'd rather cannibalize their own business than let competitors gobble up market share by cutting their prices. EMC (EMC) , for example, has decided to do this by producing a lower-priced line of storage systems that compete with its own higher-priced products. Sure, that hurts margins at EMC, but it keeps control of pricing in the storage market in EMC's hands and prevents competitors from building the market share that would enable them to move up-market and attack the high end of EMC's product line. I think the strategy is sound; just look at Sun Microsystems (SUNW) - Get Report to see what can happen if a technology company doesn't cannibalize its own high-end products quickly enough. But Wall Street almost automatically punishes the stocks of companies where profit margins are declining. The result is an all-too-familiar puzzle: The strategy that has the potential to pay off in long-term success for the company, its stock and investors winds up hurting the stock in the short term.

Two Ways to Turn a Profit

If you want to make money from technology stocks while the companies in the sector are fighting their way through this kind of tough competitive environment, an investor can either 1) buy those technology stocks when they've been beaten down to the bottom of their price range and sell them at the top of the range (and repeat); or 2) buy stocks that are positioned to avoid all, or at least the worst, of this competitive pressure.

I'd put these stocks in the first group:

AU Optronics

(AUO)

,

Micron Technology

(MU) - Get Report

and EMC. Readers of Jubak's Journal are familiar with the travails of Micron Technology, a leading maker of memory chips, and EMC, the leader in storage hardware and software. Both are cheap enough now to make a swing to the top of their trading range, and both are reasonably profitable.

Flat-screen maker AU Optronics has been pummeled by oversupply in its industry (and by falling prices). It now looks like supply and demand will move to something like balance around the middle of the year. I'd look for a potential move to $20 for these shares. I already own EMC and Micron in

Jubak's Picks, so I think I have reasonable representation among these swing-trade candidates.

In the second group, I'd put

ChoicePoint

(CPS) - Get Report

,

Copart

(CPRT) - Get Report

and

Yahoo!

(YHOO)

.

Notice what these stocks have in common? None of them make anything tangible, so they escape the worst problems caused by excess manufacturing capacity. They're all in the business of using technology to collect and distribute data, and they sell services -- credential checks, online auction sales and online advertising, respectively. And they each have strong competitive advantages, ranging from brand name to market share, that make it tougher for competitors to go after them on price.

I'm adding Yahoo! to Jubak's Picks with this column.

Changes to Jubak's Picks

Sell Texas Instruments.

The stock is now near the top of its recent price channel, and that makes it time to sell TI. This stock is, in my opinion, stuck in a trading range. I'm selling with a 17% gain since I added the stock to Jubak's Picks on Oct. 8, 2004 at $22.05.

Buy Yahoo!.

I like what Yahoo! isn't. It is not a technology company facing a margin squeeze from rising raw-materials costs or falling prices. I also like what Yahoo! is: an Internet advertising leader benefiting from the resurgence of online advertising, from growth in the hot new category of sponsored search and from the fast-growing fee business at Yahoo!. No stock trading at a price-to-earnings ratio of just below 60 is cheap or anything less than risky. The stock has pulled back to fall through its 50-day moving average and is now near the 200-day moving average that has often provided support for the stock in the past. It may take a little patience, but I think investors willing to wait will see this momentum favorite re-establish itself. As of Feb. 15, I'm adding Yahoo! to Jubak's Picks with a target price of $45 by July 2005.

At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: EMC and Micron Technology. He does not own short positions in any stock mentioned in this column. Email Jubak at

jjmail@microsoft.com.