Taking Stock: Can Tech Stocks Sustain The Warm-Up?

The weather has turned cold out here on the West Coast, reminding everyone that winter is soon here. Once again, we dare to open our financial statements. For most tech investors, this has been a banner year, though revenue growth has varied dramatically in different parts of the industry.

Stocks in the Internet-software and computer-storage sectors jumped 153.7% and 105.9%, respectively, as of Nov. 20. Anything Internet-related was crushed over the preceding three years, both from stock-market and business perspectives. But this year, Internet-software companies strung together back-to-back quarters of high-revenue growth, increasing more than 30% year over year for the last four quarters. Still, Internet-software companies come with a lofty valuation in the form of a price-to-earnings multiple of almost 62 times projected 2004 earnings per share.

Storage companies also have experienced solid revenue growth. The demand for storage in consumer electronics, such as memory for digital cameras, has driven some of this growth. However, revenue growth has accelerated from a rate in the low teens four quarters ago to more than 20% this past quarter. This sector is trading at a not-too-meager price/earnings ratio of more than 30 times 2004 estimates.

Two sectors stand out for delivering poor revenue growth but excellent stock-market returns. The first is the communications-equipment sector. Very modest revenue growth reappeared this past quarter after many quarters of no growth or declines. Tech investors have frantically bid up these stocks 90.9% this year. The other sector is semiconductor capital equipment, up 85.9% year to date, but the lack of revenue growth remains an issue. The sector posted revenue declines of 8.2% and 11.4% for the last two quarters. Investors anticipate that the promised upswing in this sector is real--and judging from the increase in orders, that appears to be true.

The system-software sector hasn't been a great performer this year. Companies like Microsoft and Oracle have delivered single-digit revenue growth and seem unlikely to grow much faster in the near term. The stock-market returns have likewise been uninspiring, with the sector returning only 11.6% this year. But these numbers mask the impressive growth that Macrovision, Symantec, and Veritas Software, among others, have posted.

Data-processing companies have delivered steady revenue growth of approximately 10% for each of the last several quarters. Stocks in the sector are up only 14.0% this year, as investors focus on companies of a more speculative nature.

It's hard to imagine that tech stocks will deliver the same eye-popping returns next year, with their lofty valuation of almost 32 times '04 consensus earnings estimates. Revenue growth will undoubtedly continue as the economic recovery picks up, but expectations are rather high. Disappointing growth from tech companies likely will be viewed very negatively. Selectiveness probably will be a virtue in the upcoming 12 months.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected]. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with, nor does it receive compensation from, any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.