Why Tech Stocks Look Better—Even for the Risk Averse

The technology sector is known for two things: growth potential and risk.

Apple's trouncing of Wall Street earnings forecasts this past week suggests growth is still abundant. Yet Big Tech is looking less risky than it has in the past.

Here are four reasons conservative investors should consider adding exposure to tech stocks.

An Apple store in New York: Apple holds more than $97 billion in cash and securities.

Valuation. Tech stocks have had more than a decade to work off the bloated share prices from the dot-com stock bubble of the 1990s, says Cliff Hoover, chief investment officer of Dreman Value Management in Jersey City, N.J., which manages $5 billion. Many have become a good home for safety-oriented investors, he says.

The information-technology sector of the Standard & Poor's 500-stock index recently traded at 13 times estimated 2011 earnings, on par with the broad index, according to S&P data. The consumer staples and utilities sectors, typically considered safe and stodgy, fetch 14 times earnings. And Wall Street expects the tech sector to increase its earnings by almost 14% in 2012, versus 8% for consumer staples and 1% for utilities.

! Volatility. Over the past five years, large pockets of the tech sector, including hardware makers, systems software firms and consulting shops, have been no more volatile in terms of share-price changes than the broad S&P 500 index, according to S&P data.

Financial strength. The tech sector of the S&P 500 sits on $380 billion in cash and equivalents, more than any other sector and equal to 15% of its market value, according to Howard Silverblatt, senior index analyst at S&P. That doesn't include holdings in long-term securities. Apple holds a $67 billion portfolio that is "very liquid," Mr. Silverblatt says.

The two largest companies in the sector, Apple and Microsoft, have forward price/earnings ratios in single digits after deducting their cash and investments from their stock-market values. Microsoft and Intel now have fatter "dividend yields," or the percentage of share price paid out as dividends, than the 500 index average.

Mr. Hoover, who considers himself a "deep value" stock picker, likes Microsoft, Intel, Cisco Systems and Applied Materials. "They're big free-cash-flow generators and pretty good dividend payers," he says. Microsoft pays 2.7%, Cisco 1.2%, Intel 3.1% and Applied Materials 2.6%, versus 2% for the broad S&P 500.

Low expectations. With 37% of S&P 500 companies having announced December-quarter earnings results, 68% of the technology companies that have reported have beaten analysts' estimates, versus 59% for the index and 40% for consumer-staples companies, according to a Friday report from Thomson Reuters. (Only three utilities have reported, with one beating estimates.)

Tech outfits are doing well in part because companies that delayed technology purchases during the 2008 financial crisis are starting to spend, says David B. Armstrong, co-founder of Monument Wealth Management in Alexandria, Va., which oversees $200 million.

"Techno! logy has become more of a necessity, and companies can only delay investments for so long," he says. "That helps make the sector more stable."

When hunting for tech stocks, investors should consider not only traditional factors like valuation and income growth, but also the "network effect," says Kishore Rao, a research principal with Sustainable Growth Advisers in Stamford, Conn., which manages $3 billion in pension funds and other assets. The term refers to goods and services becoming more valuable as more people use them. For example, securities exchanges benefit from the network effect because as they attract more traders they become better able to handle additional trading volume.

Mr. Rao cites eBay's marketplace, Google's search advertising and Apple's community of mobile-application developers as examples of the network effect. "There's a high degree of predictability for these companies," he says. His firm, which tends to hold 25 to 30 stocks at a time, invests in all three companies.

Another factor to consider beyond financial results is "switching costs," says Grady Burkett, an analyst at Morningstar. The best companies are ones whose customers would find it a burden to switch to competitors, he says.

That typically means companies with plenty of large business customers, such as Cisco and Oracle, Mr. Burkett says. He calls Apple a rare example of a consumer-focused business with high switching costs because customers are attached to its music, photo and other applications. "They'll find it harder to give up their iPhones than they did their Motorola flip phones years ago," he says.

Of course, the technology sector remains exposed to sharp economic downturns, says David Roda, an investment strategist at Wells Fargo Private Bank. But breakthroughs in areas like mobile computing and Web-based, or "cloud," services are "just beginning," he says, and emerging markets have shown a voracious appetite for technology.

Mutual-fund investors who favor portfolios run by ! stock pi ckers should look for long-tenured management, solid returns and limited volatility, says Flynn Murphy, a mutual-fund analyst at Morningstar. He highlights two examples: Columbia Seligman Communications & Information, which has returned an average of 6.6% a year after expenses over the past 10 years, and Waddell & Reed Advisers Science & Technology, which has returned 7% a year, according to Morningstar data. The category average is 3.3% a year. Returns for both funds are for Class A shares, which carry upfront sales charges of up to 5.75% and yearly expenses of 1.36%.

For investors who chafe at high fees, exchange-traded funds like Vanguard Information Technology and Technology Select Sector SPDR offer broad exposure to technology at yearly expenses of 0.19% and 0.20%, respectively.

Another option is a more broadly focused mutual fund that happens to favor tech. The Oakmark Global fund, one of Morningstar's top picks, has 35% in tech, versus an average for world stock funds of 14%, Mr. Murphy says. It has returned 9.0% a year on average over the past decade, versus an average for world stock funds of 5.2%. There isn't an upfront sales charge, and yearly expenses are 1.16%.