NEW YORK (CNN/Money) -
There's a lot to look forward to in 2004.
My wedding, for one. (Isn't that sweet?) Shrek 2. (Donkey!) The New York Giants without Jim Fassel as head coach. (From Super Bowl dreams to 4 and 10?)
If none of that excites you as much as it does me, at least there's one thing all tech investors can look forward to: a nice rally in software stocks.
The group has done reasonably well in 2003, marked by a 33 percent gain in the Amex Software Holders trust this year. But that's paltry next to the Goldman Sachs Hardware index, up 48 percent, the Philadelphia Semiconductor index (up 67 percent) and the Amex Network index (86 percent).
What's more, many of the software sultans have really slumped. Microsoft (MSFT: Research, Estimates), after all, is up a puny 3 percent.
BEA Systems (BEAS: Research, Estimates) and Intuit (INTU: Research, Estimates) have each risen less than 10 percent.
PeopleSoft (PSFT: Research, Estimates), despite being involved in a takeover battle, is up only 12 percent while its hostile pursuer Oracle (ORCL: Research, Estimates) has increased just 18 percent.
Everybody rotate
With this in mind, it's reasonable to expect some good old-fashioned sector rotation, with professional investors scaling back on some of the year's big winners in favor of software laggards.
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It's already beginning to happen. Matt Kelmon, president of Kelmoore Investment Management, said he's been paring back positions in semiconductor stocks that have run up substantially this year but is still bullish on software underperfomers such as Microsoft, Oracle and Tibco (TIBX: Research, Estimates), a small cap business software developer that is down slightly this year.
There is also a solid fundamental case for software.
William Batcheller, manager of the Armada Large Cap Growth fund, said that the time is right to move from chips to software since that's how tech cycles usually work: semiconductors and hardware sales pick up first and then after businesses have bought new PCs and servers, software begins to rebound.
"The backdrop for software is pretty good. Tech spending looks like it's going to be up next year, and even though it's not expected to be huge, software is a good-sized component of that," said Batcheller, who owns Microsoft, Oracle, Intuit and BMC Software (BMC: Research, Estimates), a mainframe software developer that has fallen slightly in 2003.
In fact, Oracle reported surprisingly upbeat fiscal second quarter results on Monday, which has renewed hopes that corporations are finally starting to increase their spending on software.
That's a good sign for the whole software group, not just Oracle.
And Oracle's news came on the heels of a superb report by graphics and publishing software designer Adobe Systems (ADBE: Research, Estimates) last week.
Overall, the average estimated earnings increase for next year for 41 software companies with a market value of at least $1 billion is 39 percent, according to Thomson/Baseline.
So the group's average P/E of 33 times 2004 earnings estimates, while not cheap, is probably reasonable, especially when you consider that chip stocks with a market value of at least $1 billion are trading at 46 times 2004 estimates.
Merger speculation should move stocks
Another factor that could send stock prices higher for the whole group is that software consolidation is expected to continue at a frenzied pace. If Oracle is unsuccessful in its attempt to win the battle for PeopleSoft, odds are it will turn somewhere else.
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Hewlett-Packard (HPQ: Research, Estimates) has hinted at doing software deals as well.
And storage company EMC (EMC: Research, Estimates) has shown a voracious appetite for software companies. It announced Monday that it was buying a hot private software firm called VMware for $635 million. EMC has already made two other large software acquisitions this year, scooping up Legato Systems and Documentum. The price tag on each purchase was more than $1 billion.
As long as there's more merger mania in the group, that should drive up the values of smaller companies as Wall Street places bets on who's next.
So mark my words. If you're looking for something to count on in 2004, here are some certainties.
The United States won't win the gold medal for baseball in Athens. (The team didn't even qualify for the Olympics!)
The presidential campaign will be nasty. (Yeah, I'm really going out on a limb there.)
And software stocks will have a strong showing.
"People will move into software next year. It's a question of when, not if," said David Hilal, an analyst with Friedman Billings Ramsey.
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