Tech Stock Favored By Star Fund Managers

All the rotation talk these days is centered on whether we're on the precipice of a big move out of bonds and into stocks. That can obscure a potentially more important rotation investors need to consider: taking some profits where valuations have gotten a bit high (hint: the consumer discretionary sector and its 18.9 average forward PE ratio is a likely hunting ground) and redirecting money to the less pricey.

The Leuthold Group is making the case that technology stocks should be on your radar. Yes, it has lagged badly of late; the year-to-date performance of Vanguard Information Technology (VGT) and the SPDR Technology Select ETF (XLK) lag the S&P 500 by almost four percentage points and seven points, respectively.

VGT data by YCharts

Of course, the near 12% year to date decline for Apple (AAPL), the biggest position in both those ETFs -- and any market weighted index for that matter -- is the big brick holding down performance.

What has Leuthold's eye is that the sector's 12.6 median price to cash flow puts it in line with the S&P 500; that's the first time in 20 years it has been so cheap. They also like the sector's trailing PE ratio and normalized PE ratio relative valuation. (Leuthold's normalized PE is a five-year mash up of 4.5 years of actual earnings combined with six months of forward estimates.) In Leuthold's August report it concludes that technology “is shaping up as perhaps the best contrarian theme among the broad sectors.”

The firm's domestic allocation currently has a 21% weight to technology, up from 12% a year ago. Only financial stocks at 22% have a higher weight.

At the end of the second quarter, the Leuthold Core Investment mutual fund -- a mix of stocks, bonds, and cash -- had added to tech stakes including Western Digital (WDC), Seagate Technology (STX) and EMC (EMC). In its July “Green Book” report, Leuthold walked through a new 4% addition to its equity holdings focused on the tech sub-industry of electronics manufacturing services firms. The four biggest positions are TE Connectivity (TEL), Trimble Navigation (TRMB), Flextronics (FLEX) and Jabil Circuit (JBL).

The TE Connectivity stake is double the size of the three other holdings. It also is the single largest holding of the index-beating Artisan Global Value mutual fund, accounting for 4.1% of fund assets. The Artisan team first bought the stock in the second quarter of 2011; last quarter it increased the position by more than 40%. TE Connectivity is also in the top 10 holdings of the top rated Oakmark Global mutual fund. Oakmark, also a value shop, has owned the stock since 2007, but it, too, added to its position -- about 3.1% recently -- last quarter.

The EMS segment of the tech sector designs and manufactures electronic components used by original equipment manufacturers (OEM) in just about every market, from consumer electronics to automotive and aerospace and energy. The global leader is Taiwan's $30 billion Hon Hai Precision (HNHPF).

The $21 billion Swiss-based TE Connectivity (it trades on the NYSE) generated 39% of its 2012 sales from auto OEMs and another 21% from the telecom industry. Eight other segments (computers to aerospace& defense) each delivered single digit shares of the firm's $13.3 billion in sales.

Leuthold estimates that revenue for the EMS group has grown an average of 8% annually for the past four years as more OEMs want to outsource manufacturing. Total group revenue last year was $300 billion.

The allure right now is compelling growth prospects and good (not expensive) valuations. Leuthold also layers in some technical analysis to its research, as trends complement fundamentals. The technicals for the group are also moving in the right direction. That said, this is a volatile segment of the market -- demand is cyclical -- and many companies are reliant on a small number of clients. The average beta is 1.28.

TEL Beta data by YCharts

That give you pause? Again, these are small positions. And keep in mind, while low volatility has been the theme du jour (or annee), beta has in fact been delivering for the bold.

TEL data by YCharts

Leuthold's focus on the segment is as a “first derivative play on the success of large OEMs such as Apple, HP (HPQ), Lenovo (LNVGY), Microsoft (MSFT) and Cisco (CSCO).”

That said, sales to network enterprise and computer OEMs accounted for just 10% of TE Connectivity's sales last year. That's probably a good thing, as right now those segments aren't exactly delivering growth; network sales declined 3.6% in the most recent quarter and computer revenue was down 12%. Still, earnings per share rose 11%, as the $21 billion company is riding the resurgence in auto production. Sales for the automotive division rose 8% in the quarter.

A trailing and forward PE ratio around 16 isn't dirt cheap, but it's not appreciably off of the stock's long-term norm.

Meanwhile, the company has delivered strong growth in free cash flow, while also managing to expand its gross profit margins.

TEL Free Cash Flow TTM data by YCharts

A nice kicker is a 2% dividend yield and a five-year dividend growth rate of about 10% annually.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com. You can also request a demonstration of YCharts Platinum.