Guru Strategy: Jim Oberweis says get ready for a tech sector rebound

Jim Oberweis, president of Oberweis Asset Management and the editor of investment newsletter The Oberweis Report, says that after a long hiatus, the tech sector is finally showing signs of a rebound. Wall Street veterans have long dispensed advice on "bubbles," often predicting that the bust following the boom can last for many years. In his most recent newsletter, Oberweis and portfolio manager Ken Farsalas, say that investors have witnessed this firsthand -- after the "Nifty 50" bubble burst in 1973 and after the oil stock bubble burst in 1981. The stocks that were favorites on the way up lagged the broader market long after their initial, sickening drop. Technology stocks are no different, and after the tech bust of 2000, Oberweis and Farsalas say that a rebound is starting.

DailyFinance interviewed Jim Oberweis about the tech sector rebound.

DailyFinance: Jim, I know you believe the economy will continue to rebound and the tech sector could lead the way. If we are indeed saying good-bye to the bear, why should investors be in tech?

Jim Oberweis: In contrast to the last eight or nine years, this year tech is among the top performing sectors. Half way into this year, technology stocks are the best performing stocks in the Russell 2000 Growth Index, the first time they've been top dogs in more than five years. After years of lagging performance, we believe recent relative strength signals the start of a longer-term trend and is not merely a flash in the pan.

What's driving the sector forward?

Oberweis: Anticipation of sales increases in years to come. Since the technology bubble of March 2000, technology stocks have essentially lagged the broader market for the majority of this decade. The technology sector within the Russell 2000 Growth Index, for example, has underperformed the Russell 2000 Growth Index itself seven of the last nine calendar years. In short, tech stocks have been dogs for a long time.

Part of the reason for the downfall of the tech sector was that from 1999 to 2000, stocks were valued so high that investors had priced in perfection, which is something that rarely occurs. Over that period, we saw tech stocks lag even though company sales were growing just fine.

The current economic crisis certainly hasn't helped either.

Oberweis: Yes, over the last two years, corporate investment has been curtailed and after the financial crisis hit, consumers also cut spending. But some of those clouds now appear to be passing.

So what kind of a rebound do you expect we will see?

Oberweis: I don't expect robust spending, but I do think it will be easier for companies to grow off a much lower base – which is where we are now. Many tech companies are not reflecting this, so I believe that they will surprise on the upside, especially in areas such as network security, routing traffic, and meeting rising bandwidth demands of voice-over-IP and with apps like smart phones.

Tech is a big space. Is there a particular segment of technology that you are optimistic about?

Oberweis: I think that the convergence of computing and cell phones into one device, such as the iPhone, is a trend that is not reversible. We're going to see many more smartphones hit the market in the years ahead.

What else will generate growth for tech companies?

The next killer apps, because they drive technology cycles and because they change how we live our lives. During the 1980's and early 1990's, the personal computer was the killer app. During the late 1990's, it was the Internet. During this decade – zilch.

But it's coming. I think the next killer apps will be technologies that utilize bandwidth and the Internet ubiquitously via small intelligent devices like the smart phone. This means that video-on-demand is likely to have explosive growth. Companies like Netflix (NLFX) are turning to technology to take a shot at it. Besides content providers, companies that route traffic across networks are well-positioned because of the exponential increase in Internet traffic. You will soon be able to watch TV just about anywhere.

You have mentioned wireless smartphones a number of times. Is wireless, in your view, a real driver for technology?

Yes. Smart phones and cruising high-speed wireless networks will morph from boring cell phones into robust, multi-functional devices. Apple's (AAPL) iPhone, after all, is really a mini-computer that just happens to have phone capabilities. Frankly, the product's name doesn't do it justice. Just as Apple's unique graphical user interface in the original Macintosh accelerated the proliferation of computers, its revolutionary iPhone marks the start of the real smart phone revolution.

Many people who have an iPhone use it less as a phone and more as a computer. Applications evolve once they have a critical mass of users.

So assuming a more favorable technology backdrop, how should investors evaluate potential technology

Every tech cycle and the technology business can be tricky and fast-moving. But here are some basic tips:

Try to identify technology stocks levered to Killer Apps and avoid slow-growth parts of the technology industry. Target companies tied to smart phones and video-on-demand. Avoid stocks that depend on the PC market, which is now a mature, slow-growth industry.

Look at a company's revenue growth rates. Are sales growing rapidly and accelerating? Do consumers thirst for more of what the company makes?

Target proprietary products and avoid companies that make commodity-type products. If you lack a degree in computer science or electrical engineering, a good way to do this is to examine a company's gross profit margin on their income statement. High gross margins north of 40 percent signal that a company makes something relatively unique – at least for now. Low gross margins imply that products are "me-too" and that the primary method of competition is based on price. Even better, look at gross margins over the past few years to see if they are expanding. Contracting gross margins are a red flag that competition is heating up.

Can you give us specific stock recommendations for investors to play a stronger technology market?

I would recommend Synaptics (SYNA) a company which makes the interface for PCs and smart phones. It's a great way to play the growth in tech because its not making a bet on any one product, but on touch interfaces of many smartphones. Although Synaptics' touch screens are not used by Apple, the company has secured design wins for competing smart phones from Research In Motion (RIMM), Nokia (NOK), and LG. The company grew revenues 28 percent year-over-year last quarter and had 42 percent gross margins.

Another company I like is Starent Networks (STAR) which manufactures wireless infrastructure equipment used by cell phone providers to deliver high-speed functionality to their customers. Starent's equipment is the backbone that helps wireless networks operate at broadband speeds. The company grew revenues 30 percent year-over-year last quarter and had 80 percent gross margins.

Finally, investors should look at Netlogic Microsystems (NETL) which designs "knowledge-based" processors
that allow network providers to prioritize network traffic, slowing down low priority traffic like emails and accelerating delivery of high-priority traffic like streaming video. Network optimization helps make video-on-demand a reality. The company saw revenues contract last quarter because of the slumping economy, but had 69 percent gross margins. Revenue growth should re-accelerate in the coming quarters.

Jim Oberweis is the Editor of The Oberweis Report. For more information, click here.
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