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If 2003 was the year investors rekindled their romance with hardware stocks, 2004 could be software's turn as belle of the tech ball.

After lagging behind the

Nasdaq Composite's

impressive gains this year, the software sector is poised to become the main attraction in 2004, presuming information technology managers loosen their purse strings.

"I think software will do better, although I don't think hardware will do poorly" next year, predicted Kevin Merritt, a software analyst with Fiduciary Trust Co. International in New York. Software "has got the most leverage in it, if anyone starts spending again."

Software companies typically boast higher margins than hardware vendors -- with the exception of some select chip companies -- because there are no incremental manufacturing costs since software is really just code, distributed to customers on CDs or downloads. So, increases in software sales typically lead to an even larger boost in the bottom line since there's no corresponding rise in expenses.

The problem in 2003 was companies kept a tight rein on IT spending, keeping a lid on software sales and minimizing the size of deals that did get done. Meanwhile, consumers forked over tons of money for things like digital cameras and laptop computers, fueling strong results in the hardware sector.

Consequently, software giants such as

Siebel Systems

(SEBL)

and

Oracle

(ORCL) - Get Oracle Corporation Report

are still suffering year-over-year license revenue declines, while hardware heavyweights like

Intel

(INTC) - Get Intel Corporation Report

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and

Dell

(DELL) - Get Dell Technologies Inc Class C Report

have been projecting double-digit revenue growth.

The dichotomy was reflected in the performance of the two sectors. As of Dec. 10, the Goldman Sachs Software Index was up about 35% in 2003, far better than its 44% decline in 2002. But software still trailed well behind the 57% jump in the Philadelphia Semiconductor Index, the 41% gain by the Goldman Sachs Hardware Index, as well as the nearly 38% climb in the Nasdaq Composite.

The good news for those long software stocks is that kind of performance is typical at the beginning of economic (and stock market) recoveries. The Wall Street playbook dictates that more cyclical hardware stocks rally first, followed by software. Given the first part of the equation transpired in 2003, it's understandable why many money managers expect 2004 to be the year of software.

But off of Wall Street, Joshua Greenbaum, a principal with technology consultancy Enterprise Applications Consulting in Daly City, Calif., argues there's no real rule of thumb regarding which sector follows which in an economic recovery, though he agrees hardware is more cyclical.

"I've always found it shortsighted for Wall Street to link hardware to software," Greenbaum said. "It's one of my pet peeves."

"Enterprise software gets installed primarily on existing hardware, and, at any rate, is not dependent on a change in desktop or systems hardware," Greenbaum explained. "I also think hardware is in a much faster race toward commoditization than software," he added.

Still, most traders are short-term oriented and the

perception

that software does better later in economic cycles definitely persists on Wall Street.

Further working in the software sector's favor is that IT spending confidence has bottomed. On average, IT executives expect to increase their spending 4.3% in 2004, Gartner and SoundView found in a survey this month of more than 600 respondents. Conversely, Carly Fiorina, CEO of tech giant

Hewlett-Packard

(HPQ) - Get HP Inc. Report

, recently predicted IT budget growth of a mere 1% to 2% in 2004, an outlook consistent with surveys by Merrill Lynch.

Whichever of those forecasts proves most accurate will largely determine the software sector's fate in the coming year.

"At the end of the day, IT spending is going to dictate what spending on software does," says Tim Allen, a vice president and senior portfolio manager for Wentworth, Hauser and Violich in Seattle.

Noting Oracle's hostile takeover bid for rival

PeopleSoft

(PSFT)

, Allen believes more consolidation is on the way because the growth in IT spending just isn't there to support so many software players.

More deals would likely give a boost to takeover targets. Other oft-speculated candidates include

BEA Systems

undefined

,

i2 Technologies

(ITWO)

and

Retek

(RETK)

.

Software stocks also stand to go up as hardware investors become increasingly jittery about their gains. The SOX's 10% decline in the first 10 days of December is a sample of some of the volatility that can hit that group.

"It's not so much that I think software is ready to take off as much as I'm concerned that hardware has gone too far," says Duane Roberts, portfolio manager at Dana Investment Advisors in Dallas-Ft. Worth. Roberts is looking to increase his software holdings, currently limited to

Microsoft

(MSFT) - Get Microsoft Corporation Report

and

Symantec

(SYMC) - Get Symantec Corporation Report

. "The valuations in general for software companies are much more attractive," he said.

With a price-to-earnings ratio of 23 times forward earnings -- vs. a software benchmark of 30 and a P/E over 50 for the Nasdaq 100 -- industry bellwether Microsoft is "pretty attractive" for a tech stock, Roberts declared. Microsoft shares have been weighed down by concerns over unearned revenue, a European Union antitrust investigation, Linux competition and security problems. But "we like the cash generation, the predictability of their earnings," Roberts said.

If more investors agree, Mr. Softee could lead software's move from wallflower to the life of the tech party.