Small-Cap Tech May Lure Investors Bullish on Growth

The investment outlook for small-cap technology companies is improving as cheap valuations and conservative earnings estimates make them more attractive, after being weighed down by concerns about the economy.

Small-cap businesses are expanding to provide additional products and services — including the delivery of storage, software and other computing tasks over the Internet “cloud.” This is boosting sales, as valuations and estimates for 2012 earnings remain moderate, said Steven DeSanctis, head of U.S. small-cap strategy at Bank of America Merrill Lynch Global Research in New York.

With cash-flush balance sheets that account for about 20 percent of their market capitalization, tech stocks are poised for “pretty good” growth after last year’s “laggard performance,” he said. The cash hoard is attracting investors because companies may use it to pay dividends, repurchase stock or make acquisitions, he added.

The Russell 2000 Technology Index — currently made up of 292 businesses with market cap of less than $3.45 billion — has risen 21 percent since Sept. 6, 2011, compared with a 20 percent gain for the Russell 2000. This follows almost seven months of underperformance, when the tech stocks lagged behind the Russell 2000 by 8.9 percent.

The tech index has been held back by investor worries about global growth, according to Lawrence Creatura, who helps oversee $363.6 billion as a fund manager in Rochester, New York, at Federated Investors Inc.

Investor Opportunity

“While this sector has enjoyed strong earnings, it hasn’t enjoyed robust price appreciation so far this year,” Creatura said. “Within that may lie an opportunity for investors,” because these companies benefit from strong balance sheets and better valuations than other industries, he said.

Small-cap tech stocks have “moved sideways” relative to the Russell 2000 during the past eight months, reflecting a lack of market interest, said Jim Stellakis, founder and director of research at New York-based research company Technical Alpha. The tech index is holding at a so-called triple bottom on a weekly relative basis: when stocks reach a particular level three times without trading below it.

That’s bullish, indicating buyers still are willing to invest at the same lows reached in September and January, he said. If the group were to trade below this level, it would signal that sentiment has become more pessimistic, he added.

These companies are very sensitive to the economy, and “during times of fear and uncertainty, investors don’t rush to buy,” Creatura said.

Slower Growth

The U.S. expanded at a less-than-forecast 2.2 percent annual rate in the first quarter after a 3 percent rise in October-December, data from the Commerce Department show. The median forecast of economists surveyed by Bloomberg News called for 2.5 percent growth.

While demand for Unisys Corp. (UIS)’s system and security services remains “difficult,” the Blue Bell, Pennsylvania- based company is “not necessarily controlled by those macro trends,” Chairman and Chief Executive Officer Edward Coleman said on an April 24 conference call. He is “encouraged” by customer interest, with orders for services growing at a double- digit rate through the second consecutive quarter, he said.

The tech companies are attractive because their valuations are historically cheap and 2012 earnings estimates are lower than those for the Russell 2000, even as the U.S. expansion has slowed, DeSanctis said. The group is trading at a premium of about 17 percent relative to all small caps on a price-to- earnings ratio, compared with its average premium of about 29 percent.

Low Bar

The analyst consensus calls for earnings to grow about 1.3 percent this year, which compares with almost 17 percent for the broader index, so “the bar isn’t set too high for these companies to exceed estimates,” DeSanctis said.

Unisys rose 20 percent on April 25 after reporting first- quarter earnings the prior day that beat analysts’ estimates, according to data compiled by Bloomberg.

Even so, shares for the industry have experienced “a pullback” since February, which may indicate “some of the macro concerns are filtering through,” DeSanctis said. It “doesn’t bother” him that as much as 40 percent of the industry’s sales come from outside the U.S., because earnings estimates already “reflect weaker economic issues in Europe, whereas the Russell 2000 stock index probably doesn’t fully reflect slower growth in the U.S. and abroad.”

Macroeconomic Storms

If “tomorrow’s macroeconomic storm clouds darken further,” investors may become more defensive, causing the industry to continue to underperform, Creatura said.

“The credit squeeze that’s holding back European economies” will last a while, weighing on investor forecasts for equity growth, said Carl Weinberg, chief economist and founder of High Frequency Economics Ltd. in Valhalla, New York. “This is a slow ship to turn around.”

The French presidential election increases the uncertainty because Francois Hollande, the Socialist front-runner, has said he disagrees with European Central Bank President Mario Draghi’s plan for fueling expansion in the 17-nation euro area. Draghi called April 25 for a “growth compact” to complement a fiscal treaty approved by European leaders. German Chancellor Angela Merkel endorsed the proposal.

The compact may counterbalance some concerns stemming from austerity measures countries have adopted, Weinberg said. “We’ll have to wait and see what kind of changes that growth compact will bring, but it may be positive.”

‘Real, Robust’

Meanwhile, the U.S. recovery is “real, robust and here to stay, as long as nothing happens in the banking system,” Weinberg said. His company projects GDP will rise 3 percent this year. That compares with 2.3 percent for 2012 and 2.5 percent next year, according to the median estimates of economists surveyed by Bloomberg.

Even though Europe and China were “strong headwinds” for LeCroy Corp. (LCRY) during its third quarter, there are “sustainable business opportunities” in the U.S. for the maker of equipment to analyze disk drives, President and Chief Executive Officer Thomas Reslewic said on an April 25 conference call. The “overall market dynamic” still is “very good” for the Chestnut Ridge, New York-based company, driven by demand related to mobile devices, cloud computing and data-communication infrastructure, he said.

The industry can “weather a lot of storms” and is showing “characteristics for success in 2012,” DeSanctis said. “It’s very attractive for investment right now.”

By Anna-Louise Jackson and Anthony Feld

Courtesy of Bloomberg News

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