Friday July 13, 2012
by Paul McWilliams, editor Next Inning
I decided to evaluate dividend-paying tech stocks to develop a strategy that targets income, value, and growth potential. With a goal to top the S&P 500 in each of these three fundamental categories, I’m calling this the “Triple Crown Tech Portfolio."
We’ll start with 28 tech stocks that offer dividends, set some evaluation standards, and then begin whittling the list down to a more manageable number that will meet our objectives.
To start, I decided one of my goals should be to target as closely to a 3% annual yield as I could without overly compromising the other two goals of value and potential growth.
Despite its high yield, we removed Noka (NOK), as it definitely won't make the cut as a value stock. We also removed STM Microelectronics (STM) as I feel it is too speculative to pass our value test.
And while I think Altera (ALTR), Broadcom (BRCM) and Oracle (ORCL) merit consideration in isolation, their low yields don’t support the stated goal of targeting a list that produces as close to a 3% yield as we can.
A yield threshold of 1.8% also disqualifies IBM (IBM) and Jabil Circuits (JBL). These are again both stocks that I think merit consideration in isolation. However, I see both as presenting too much compromise to make the final cut.
With our field now down to 21 that are all expected to report a profit for the fiscal years under consideration, we need to take a closer look at implied “value.”
I'm using Enterprise PE instead of traditional PE because it gives consideration to balance sheet value and, with that, levels the playing field. This move eliminates Tellabs (TLAB) and Intersil (ISIL).
With the most obvious eliminations out of the way, we’ll have to make some calls that are more driven by judgment than by the fundamental data points.
Hewlett-Packard (HPQ) is another potential turnaround story that we can cut for several reasons, including higher risks than I want to accept here coupled with a relatively low yield,a nd a heavily leveraged balance sheet.
The competitive atmosphere that I see developing in the touch screen market will work against Cypress Semiconductor (CY), so I think it’s best to remove it from the list.
While I think Texas Instruments (TXN) will be a reasonably good performer over the long haul, with it now trading above my mid- $20s entry target, yielding return of only 2.4%, and showing an enterprise PE of 16.2.
I've been an Apple (AAPL) bull for most of the last decade. But I think cutting AAPL is the right move for this focused exercise; particularly in a market cap weighted portfolio where AAPL would end up dominating about half of the total allocation.
I think there is a very good prospect for continued growth in the demand for contract semiconductor fabrication. But Taiwan Semiconductor (TSM) is going to need to increase its capital investment and may need to reduce what has been a very generous dividend policy.
We’ve now whittled our original list of 28 in half to 14, with an average annual yield of 2.83%, and an average Enterprise PE ratio of 9.2, and a classic PE ratio (does not consider balance sheet value) of 11.6.
This means this list of stocks pays a higher yield, and trades at a lower valuation multiple with better growth prospects than the S&P 500. How can we go forward to further refine our thinking?
The following “tuned” strategy shares my ideas as to how a mutual fund executing this 14 stock strategy to balance yield, value and potential growth might allocate funds between the stocks.
Before I present this data, it’s important to state there are as many ways to allocate investment funds as there are ways to make a fruit smoothie. And, just like with fruit smoothies, the end result should be tailored to a personal level.
What I’m presenting below is just one idea that I might consider if I was to start this strategy from scratch. The average yield for this “tuned” allocation strategy is 2.85%. The straight PE is 11.9 and the enterprise PE is 9.9.
The minimum allocation of 3.4% is used for six out of the 14 remaining stocks. I used it for both Applied Materials (AMAT) and KLA Tencor (KLAC) to result in an aggregate sector allocation of 6.8%.
I used it for Dell Computer (DELL) due to its lower relative dividend yield, and the fact I have a substantial over-allocation to Intel, which covers similar sector dynamics.
I used a 3.4% allocation for Maxim Integrated Products (MXIM) partly due to the fact I already have high analog semiconductor allocations with Analog Devices (ADI) and Linear Technology (LLTC).
In addition to this, while MXIM focuses mostly on high volume market sectors, where ADI and LLTC have only minimal exposure, I think the risk of disruption is higher for MXIM relative to the other two.
I debated as to whether to include Corning (GLW) at all in the final cut, as its dividend yield is relatively low and it’s more of a materials company than a tech company.
However, due to its exposure to the fiber optics sector, which is otherwise totally uncovered, and my belief that the expansion of touch screen technology will drive higher sales for its high margin Gorilla Glass, I wanted to keep it in the mix.
Another consideration that led me to keep GLW is its newly released Willow Glass technology. While it will take a while for GLW to ramp Willow Glass revenue, I think it has the potential to be a game changer; particularly in smaller screen sizes used in notebooks, tablets and smartphones.
Possibly the most surprising 3.4% allocation on this list is Microchip Technology (MCHP). While there are a number of things I continue to view as highly favorable in the MCHP business model, I’ve more recently developed some mid to long-term concerns that a closer partnering between Japanese-based Renesas and TSM could be disruptive to some degree for MCHP’s model.
Meanwhile, Linear Technology carries slightly more than a “double weight” allocation at 13.9% and INTC carries a bit more than a 3.5x allocation at 24.9%.
In short, I view INTC as being at a sweet-spot in the rollout of its business model, and with its FinFET technology having at least a three year lead in semiconductor fabrication technology. Based on these views, INTC’s high relative dividend yield and low relative PE, I drove it to be my largest allocation percentage.
This leaves LLTC as the last “surprise” to cover. What encourages me to weight LLTC heavy at this juncture is its “vertical” market strategy today has the potential to be sustainable versus simply opportunistic.
In the past, the vertical markets LLTC addressed opportunistically were short design-cycle and short product cycle markets. This meant a market position could be disrupted fairly quickly.
LLTC’s new markets are primarily auto and medical where we’re seeing semiconductor content used in vehicles and medical devices soar. In these markets, design-cycle and product-cycles are very long.
This substantially lowers the threat of competitive disruption. I think there is room for some nice price appreciation, and more than ample cash flow to fund dividend growth going forward.
Bottom Line: The strategies and ideas presented in this report are not well-suited for every investor – please consider them simply as food for thought and judge for yourself if they support your goals and strategies.
Also important here is if you think this strategy is appropriate, I most certainly would not try to execute it in one fell swoop. As always, I think investment strategies should be executed over time and with multiple buys.
Learn more about this financial newsletter at Paul McWilliam's Next Inning.