Tech Stocks: Should You Buy the Bubble?

How to find under-appreciated bargains in the midst of the latest hype over high-tech companies.

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Can a stock sector be wildly overvalued and a screaming bargain at the same time? It can if it’s called technology.

Shares of LinkedIn (LNKD), which just went public, are trading at 1,000 times trailing earnings and 100 times what the company is projecting for 2012 profits. This has led to some investing advice that could be characterized – perhaps somewhat unfairly – as “Buy the Bubble.”

And yet, at a time when some technology stocks are skyrocketing, others really do look like classic value investments. How can LinkedIn at a P/E of 1,000 and Microsoft (MSFT) at 10 coexist in the same universe?
[time-link title=”(Read TIME’s story about whether there’s a new tech bubble in the works)” url=http://www.time.com/time/magazine/article/0,9171,2075351,00.html]

At this point in any such conversation, my friend Jack Willoughby at Barron’s always cites Confucius’ call for the Rectification of Names, which basically states that you can’t get anywhere if you aren’t really sure what you’re talking about.

So when we refer to technology stocks, are we talking only about computers and lasers, or something much broader? I would argue that there are many different types of companies that qualify as tech stocks in some sense. But they receive very different valuations and have very different prospects. To know which tech stocks to buy now, you first have to decide which of these five groups they belong to:

  1. The What’s Happening Now sector. These are the most likely to be overpriced and are stocks for traders and short-term momentum investors. LinkedIn – ’nuff said.
  2. The You Used to Be Fun sector. Remember when Applied Materials (AMAT) was hot? Few people do, even though the share price went up more than sixty-fold between 1990 and 2000. Today, the semiconductor manufacturing equipment giant has sales of more than $10 billion, practically no debt, $3 billion in cash and a 2.5% dividend yield. Yet its stock trades at a sad 11 times earnings, compared with P/Es of 15 to 22 for most blue chips. The Used to Be Fun sector is where you’ll find fairly priced tech stocks like Google (GOOG) and Oracle (ORCL), as well as contrarian picks such as Cisco Systems (CSCO) and Microsoft. You may also want to consider a basket of tech stocks, like the SPDR Technology Sector fund (XLK). For more on such choices, take a look at these recent stories by Dave Kansas at SmartMoney and Amanda Kish at Motley Fool.
  3. The Good Things Come In Small Packages sector. Juniper Networks (JNPR), with $4.3 billion in annual sales trades at almost 30 times earnings, while its chief competitor Cisco, with 10 times the annual sales (almost $43 billion), trades at a P/E around 12. In this kind of comparison, my instinct is to go with the cheap giant. But small companies can focus on market niches and gain market share more easily, so this comes down to a tradeoff between growth prospects and P/Es.
  4. The High-Tech Can Be Boring sector. Companies such as Illinois Tool Works (ITW) make sophisticated industrial equipment that incorporates a lot of high technology. Some stockpickers think this is a promising place to look for bargains because the stocks are misperceived as stodgy capital goods makers rather than cutting-edge tech stocks.
  5. The You Have Hidden Depths sector. People normally don’t think of railroads as technology stocks. But train systems present unbelievably complex mathematical problems when it comes to figuring out the most cost-effective way to move all the freight around. And the latest computer systems have been able to enhance the profit outlook for this group substantially. That’s why superstar investor Warren Buffett was supersmart to buy Burlington Northern, and why you might want to take a look at Union Pacific (UNP), the largest U.S. railroad. And next time you hear a freight train a-coming, think high tech – don’t just listen to its lonesome whistle blow.
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