3 High-Quality Tech Stocks To Target While They're Cheap

David Sterman's picture

Thursday, May 15, 2014 - 11:00am

by David Sterman

If you own stock in Facebook (Nasdaq: FB), you've had to reach for the Tums, as shares have tumbled roughly 15% since early March. Yet that pullback is just a minor inconvenience when you consider that a host of other dot-com and social media stocks have plunged by 25%, 50% or more. 

No doubt about it, the mania for richly valued tech stocks has come to an end, and the odds of a rapid climb back to their 52-week highs are quite small. 

By the time I looked at these stocks two months ago, they had shown signs of a top. (Indeed, a number of these stocks had hit their all-time highs on March 5.)

By the time I looked at this group a month later, they were in freefall. 

While almost all of these stocks had fallen more than 20% from their peaks by early April, the carnage has continued for some, while others have seen their share prices stabilize. 

Has this group hit bottom -- and is it primed for a comeback? Not everybody's convinced. A recent Wall Street Journal article suggests that some of these stocks have further to fall. 

To be sure, my recommendation of LinkedIn (Nasdaq: LNKD) last month now looks premature. Though the company has a very bright future, investors continue to fixate on management's decision to boost spending this year. Notably, forward earnings estimates now appear to have stabilized, and shares are no longer in freefall. 

More recently, I suggested that Pandora (NYSE: P) was finally safe to buy, though shares now appear to be treading water around $24, rather than posting a solid snapback as I had expected. Clearly, many investors are taking a wait-and-see toward this group, and these stocks may be rangebound until they can deliver a knockout quarter or investors again embrace these high-growth business models. 

In effect, all you can do at this point is track these stocks and figure out which ones have the most sustainable business models and reflect reasonable valuations... while keeping in mind that reasonable value is in the eye of the beholder. 

For instance, even after losing more than 40% of its value since September, LinkedIn still sports a 2015 price-to-earnings (P/E) multiple approaching 60. The only way you can justify buying this stock is if you think -- as I do -- that the company is building a strong moat around its business. 

In other words, valuations were no guidepost for these stocks when they were in the stratosphere, and they still aren't today. Instead, try to get a sense of which companies you expect will be thriving five years from now -- and which will be struggling. Pandora and Yelp (NYSE: YELP), each of which has plunged more than 40%, make good case studies.

Pandora is in an unusual position, as it is a "frenemy" of Apple (Nasdaq: AAPL), Microsoft (Nasdaq: MSFT) and Google (Nasdaq: GOOG). Those three tech giants are all courting the world's automakers to use their software as the basis for the next generation in-car infotainment systems. Each of these firms, especially the latter two, are likely to feature Pandora's app as a key part of their offering, in part because it helps blunt the impact of Apple's goal of dominating streaming radio through the iTunes app.

Pandora is well-positioned, yet lacks total control over its destiny. That helps explain why shares have only moved sideways after the recent quarterly bloodbath, even though analysts had been predicting a rapid rebound back to previous highs. (My colleague Marshall Hargrave recently profiled Pandora rival Sirius, which he thinks is the better stock of the two to own.)

Yet Pandora is pulling the right levers in areas it can control. The company is investing heavily in a salesforce to help boost ad spending in key radio markets. And Pandora's positioning in the mobile app sphere is impressive: According to ComScore, it is the most widely used radio streaming app (Google Play ranks higher but isn't a pure-play radio app). 

What about Yelp, which has seen its market value tumble from $7 billion to $4 billion in less than three months? This is an area where Wall Street analysts are of little help: They have come to this stock's defense in recent weeks, which still couldn't stop Yelp from breaching key technical support levels.

For example, JMP's Ronald Josey is sticking by his $113 price target for Yelp on the heels of very strong first-quarter results. "We acknowledge the increased risk associated with owning shares given the recent market volatility; however, we also believe Yelp can continue to take share, that its 57 million reviews create a defensible content moat, that the company is taking share of local ad budgets, and that as Yelp launches new tools that close the loop and as the Platform delivers transactions, Yelp's value to its (small and midsize business) partners is likely to grow," Josey says. 

Credit Suisse analyst Stephen Ju also sees a rebound coming, with a $90 price target. He thinks the solid first-quarter results, highlighted by an increasingly effective sales force, will lead to even stronger results later this year. Still, shares of Yelp will only rally when investors are convinced that the sector sell-off has fully played out. Notably, the recent filings by hedge fund and mutual fund managers shows little new buying in this group, at least as of March 31.

Risks to Consider: These stocks would move yet lower if the bull market came to an end, as they are still relatively pricey in terms of traditional valuation metrics.

Action to Take --> Should you just move to the sidelines and avoid bottom-fishing this group? That can only be answered with your comfort level regarding risk, as these remain high-beta stocks, much more volatile than the broader market. But there's no question that companies such as LinkedIn, Pandora and Yelp represent tremendous growth potential paired with much more attractive stock prices these days. One smart strategy would be to build a small position in these names, and build on those positions as investors interest begins to rebuild in this sector.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.