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Tech Stocks

We Have The Technology

By Jason R. Koepke, on Dec. 15, 2015

The end is nigh. Or more appropriately, the end of the year is nigh. With Elliott and Roger calling for the first half of 2016 to bring a correction in US equities, we also can say that the beginning is nigh—the beginning of a buying opportunity. (See Why We’re Worried about Stocks.)

Major market pullbacks can be harrowing experiences, but indiscriminate selling also creates buying opportunities for discriminating investors. In The Value of Valuation, Elliott highlighted three steps to prepare for a bear market:

  • Step No. 1: Take profits on riskier holdings;
  • Step No. 2: Add some hedges to offset the downside in your portfolio; and
  • Step No. 3: Prepare your shopping list of high-quality stocks to scoop up when the panic peaks.

Given the huge run-up in tech stocks, the sector could be more vulnerable than others in a correction—a major buying opportunity for those with the right names on their shopping list.

By doing your homework now, you’ll be ready to pull the trigger when the time comes. We’ll lay the groundwork by highlighting some of the major structural trends underway in the tech space that have staying power and will create wealth for savvy investors.

Cloudy Days

You’re probably sick of seeing commercials highlighting how cloud computing has changed the world, but even the US government has started to make the jump with its own Amazon.com (NSDQ: AMZN) Web Services (AWS) region (GovCloud) and protocols (FedRAMP).

For large corporations, the question isn’t whether they should move their data and software to the cloud or even about their confidence in providers such as Microsoft Corp’s (NSDQ: MSFT) Azure or newly renamed Alphabet’s (NSDQ: GOOG) Google Cloud Platform. The big question for large enterprises centers on how they can transition to the cloud faster while minimizing disruptions.

For example, Amazon.com recently unveiled what is essentially a massive hard drive that companies can use to offload their data—up to the equivalent of five copies of the Library of Congress’s entire contents—to accelerate their transition to the cloud.

Taking advantage of the cloud involves much more than moving your data to a third-party provider’s system—and there’s a diverse universe of opportunities for investors.

At the most fundamental level, whether companies plan to maintain their own data centers, test the waters with a hybrid setup or buy in whole hog with a total migration, nothing will work without the right hardware and software.

The need for hardware, such as servers and routing equipment, and associated software isn’t a new development, but several important trends have occurred as data centers have taken center stage.

A shift toward cheaper, commoditized hardware that companies toss and replace every few years has squeezed higher-end server manufacturers. Companies that have felt the pain include some of the biggest names in the tech sector:

  • IBM (NYSE: IBM) sold its server business to Lenovo (HK: 0992, OTC: LNVGY) in 2014;
  • Hewlett-Packard shed more than 50,000 jobs and split into two companies: Hewlett Packard Enterprise (NYSE: HPE), which focuses on services and some hardware, and HP (NYSE: HPQ), which specializes in personal computers and printers; and
  • EMC Corp (NYSE: EMC) has sought to diversify by focusing on software for data centers and agreed to sell itself to privately held Dell.

Major transitions are also underway in the software industry. The enterprise software market previously focused on operating systems and expensive databases. Nowadays, companies opt for free and open-source replacements, such as Linux and NoSQL databases.

Corporate customers dedicate a good chunk of their software budgets to maintaining the many commodity servers bought to replace higher-end models, controlling their networks and data flow, and security solutions to keep their data and intellectual property safe.

Investors seeking exposure to cloud computing should also consider real estate investment trusts that own data centers and lease the facilities to major tech companies as well as resellers that provide services to small and midsize businesses. Roger Conrad recently cashed out of Digital Realty Trust (NYSE: DLR) for a 49 percent gain because of valuation concerns, but we remain fans of the underlying business. (See Taking Profits to Follow Our Dreams.)

Recent legal rulings and legislation in Europe and Russia, as well as growing demand, have fueled a wave of data center construction in these areas. Power players like Amazon.com. Google, Microsoft and Apple (NSDQ: AAPL) have all announced plans for new data centers in Europe. Smaller companies will likely follow suit.

Finally, investors shouldn’t overlook the growing demand for services that help to drive the transition to the cloud. Even though it takes fewer people than before to manage these cloud systems, the specialized nature of this technology frequently requires outside expertise and support—which doesn’t come cheap.

In recent years, some software companies have transitioned to a model where they give away the product and make money from associated services. Red Hat (NYSE: RHT), Splunk (NSDQ: SPLK) and privately held MongoDB are three companies that have followed this strategy.

Mergers and acquisitions activity also illustrates the extent to which established players understand the value (or margins) of consulting and providing cloud services.

This strategy underpins Hitachi’s (Tokyo: 6501, OTC: HTHIY) purchase of Pentaho, a data management and analysis platform; Oracle Corp’s (NYSE: ORCL) acquisition of MySQL and its database management system a few years ago; and Microsoft’s reported interest in Docker, a company that specializes in a solution to deploy and manage cloud services.

Investors should exercise caution when it comes to names that generate the bulk of their revenue from services. Retaining the talent needed to command premium rates and cultivate new customers has grown increasingly difficult. Differentiating themselves from competitors can also be a challenge.

Consider Rackspace Hosting (NYSE: RAX), a company that has augmented its inexpensive cloud hosting with hands-on expertise and an array of premium services—a strategy that hasn’t panned out the way management had hoped. The firm recently announced plans to provide support to companies that use Microsoft Azure and Amazon Web Services as part of a bid to provide all things to all people. The market hasn’t responded kindly.

Data Analysis and Management

The rapid adoption of the cloud platform is driven, in part, by the desire for better data processing, management and business analytics. Sifting through a company’s data—spending patterns, customer behavior, sales data, inventory levels, etc.—can unlock opportunities to improve efficiency and increase profitability. In this way, data management and analytics are the 21st century’s logistics.

A vast array of companies play in this sandbox, ranging from Salesforce.com (NYSE: CRM), which specializes in enterprise software to manage customer relationships, to Tableau Software (NYSE: DATA), which focuses on visualizing and analyzing process data. In addition to a sizable universe of publicly traded names, many start-ups and private company continue to attract venture capital.

Whether public or private, many of these companies command inflated valuations and should be viewed with a critical eye. Peter Staas highlighted three areas of opportunity in Software Update 2.0:

  • Established, pure-play software-as-a-service (SaaS) companies that should be able to deliver outsized revenue growth as their solutions win market share from traditional software packages;
  • Names that produce specialized, on-premises software that have started to transition to the SaaS model; and
  • Traditional software companies that serve the financial services industry and stand to benefit from much-needed system upgrades and onerous requirements for regulatory compliance.

These picks have generated an average total return of 33 percent, with all five open positions in the green. Investors sitting on sizable gains should consider taking some profits off the table in Salesforce.com, Autodesk (NSDQ: ADSK), Guidewire Software (NYSE: GWRE), SS&C Technologies (NSDQ: SSNC) and Tyler Technologies (NYSE: TYL)—all of which trade above our buy targets.

Cybersecurity

The pullback in cybersecurity stocks started last summer. Frothy valuations and the rising risk of a bear market means that investors should still exercise caution when adding exposure to this growth trend and gradually build their positions to take advantage of volatility.

We delved into cybersecurity’s bullish case, as well as areas of downside risk, in Pain with Future Gain.

Little has changed since then. Cyberattacks continue to happen with alarming frequency, ensuring that IT departments at organizations small and large must invest in solutions to shore up their vulnerabilities.

Within this space, we’re particularly interested in encryption and communication companies and international names that have best-in-class products tailored to non-US legal concerns. We also have our eyes on outfits that provide security solutions directly to cloud providers.

We’ll explore these opportunities at length in future issues of Capitalist Times Premium as we assemble our shopping list.

Jason Koepke heads GNT®, a data-management and technology consulting firm that serves the public and private sectors. Before becoming a consultant, Jason was an editor for and contributor to Wall Street Winners and other investment newsletters, focusing on technology and health care.

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