Nasdaq 100 Offers Cheap Stocks, Steady Gains

BOSTON ( TheStreet) -- Investors who built their stock portfolios based on the S&P 500 during the past two years to reduce risk would have been better off picking the Nasdaq 100, which offers lower volatility and stronger return potential.

S&P followers exposed themselves to weak financial and real estate stocks, which contributed to a 16% decline in the benchmark during the past two years.

The Nasdaq 100, which holds the biggest tech stocks, advanced 2.9% during that time. Since February 2005, the Nasdaq 100 has returned 4.1% annually, on average, beating the S&P's 0.2% increase.

The bullish run of 2009 has quietly petered out in 2010 as indicators post conflicting numbers and investors question whether the economy is improving. Broad market indices have started to flag as hot sectors are held back by those with lingering issues. Until employment starts to increase, investors must identify undervalued sectors to maintain their gains.

This approach is also known as an "enhanced index strategy." Its benefits can be seen in the graph below, which illustrates the performance gap between the S&P 500 and the Nasdaq 100 during the past two years.

An investor who bought stocks in the Nasdaq 100 two years ago would have lost less than an investor in the S&P 500 would have in the first year and would have gained more than the S&P investor during the most recent year.

The Nasdaq 100 not only lacks troublesome financial stocks, but it includes steady performing tech names that had no involvement in the real estate bubble that swept the market. Components Google ( GOOG), Oracle ( ORCL) and Cisco ( CSCO) are up by more than 56% during the past year, with Cisco increasing 68%. These stocks have bounced off the market's bottom as investors recognize that they stand to have a profitable recovery.

Even after the past year's strong performance, these stocks still appear cheap. Google has a PEG ratio of just 0.9, suggesting that analysts expect more growth than what's priced into the shares, and a forward price-to-earnings ratio of 16.7. Oracle and Cisco offer forward P/E ratios of 13.2 and 14.2, respectively, versus a technology sector average of 35.6.

Even some of the Nasdaq 100's laggards appear to be priced right, which means the index could continue to outperforming other benchmarks. Amgen ( AMGN) has gained about 10% during the past year but its forward P/E is a lowly 10.3, making it cheap compared to other biotech stocks, which have an average forward P/E ratio of 44.9.

First Solar ( FSLR) is another discounted stock that could help power the index's performance in the future. While investors in the solar-panel maker are tired of wondering when the stock might jump, its value metrics remain enticing. After falling about 2% during the past year, the company has a tiny PEG ratio of 0.6 with a trim forward P/E ratio of 14, compared with the renewable energy average of 52.

The Nasdaq 100 biggest weighting is in Apple ( AAPL), whose shares have doubled during the past year. Morgan Stanley ( MS) projects the shares to climb to $250 to $435 from Friday's $204.62 under bullish conditions. Bearish conditions could lead to a share price decline to $180, a loss of only 10%, Morgan Stanley says. If this report proves to be accurate, the Nasdaq 100 stands to be a benefit.

The financial industry remains the biggest issue for the S&P 500. Pending legislation and the threat of shaky asset performance amid prolonged unemployment could cause financial stocks to drag down the index.

Rather than riding the market via the S&P, investors should consider a sector rotation strategy, which could produce solid results while still minimizing risk. Active investors should consider the cheap shares of Google, Cisco and Oracle, which could gain as companies upgrade computer systems after two years of austerity in IT improvement. Indexing investors should consider the Nasdaq 100 to avoid the risky financial sector and cash in on the strength of tech.

-- Reported by David MacDougall in Boston.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.