Market volatility expected

A multidimensional game is being played out - battling today's competitors for immediate marketplace success and investing in potentially game-changing, longer-term opportunities. From an investment perspective, in order to win out in the long run, one should stay with the established companies and diversify into other industries.

US Stocks

The pace of technological advancement has shortened the product cycle. What was leading edge 6 months ago may not be now. Also, the need to have a common platform will break down more barriers in the software industry, and eventually lower cost and increase competition. Coupled with lower stock trading cost (itself a result of technology improvement), market volatility will be the norm rather than an exception, as year-on-year earnings will be lumpy, as dictated by the shorter product cycle.

In order to move forward, one has to be quick to seize innovation, turn it into products and get them to market. In an industry where being first is almost as important as being right, there has never been a higher premium on the ability to innovate. Looking at the ratio of R&D expenditure to net sales in the following table, it ranges from a high of 28% to a low of 1.5%, the big spenders tend to be the technology companies, pharmaceuticals and biotechnology, whereas, the manufacturers spent less.

In absolute dollar terms, the top ten spent more than $2 billion a year on research, and IBM tops all with over $5 billion. There are major strategic battles being waged right now on:
-UNIX servers
-the software layer known as "middleware"
-a big shift in the semiconductor business, where the centre of gravity is moving away from PC processors to high-end server-class microprocessors at one end, custom logic chips at the other, and network processors in between.

A multidimensional game is being played out - battling today's competitors for immediate marketplace success and investing in potentially game-changing, longer-term opportunities.

From an investment perspective, in order to win out in the long run, one should stay with the established companies and diversify into other industries. In this context, old "Big Blue" wins out, and in the other industries category, Boeing (BA $60) and Eastman Kodak (EK $43.85) look interesting.

For Juniper, though it is taking market share from Cisco, but its net sales is only 3.6% of CSCO. DELL remains a PC assembler, not spending much on R&D.

US Technology Stocks

"Warning, visibility ahead is near zero, please reduce speed and navigate cautiously". This statement effectively summarises the current business cycle within the technology space (especially within the hardware equipment segment).

With a deceleration in economic activity in the US, corporate spending has geared down to sub-cruising speeds. We believe the focus of IT spending for the year 2001 will target technology add-ons that will help corporates optimise value from their existing infrastructure (rather than spending to enhance revenue reach). As such, we expect the hardware equipment segment of the technology sector to continue experiencing a depressive revenue growth outlook until summer approaches. On a relative basis, we expect software companies that enable corporate entities to maximise value from current assets to perform better in 1H01.

Rather than focusing on depressed segments (networking, semiconductors and PC makers) within the technology space and forecasting the bottom of the current down cycle (high risk exercise), we prefer to draw attention to areas that will perform in the present regime. We like software companies best and within this realm, we expect B2B application/enabler companies to be out-performers (albeit a general slowdown in IT spending).

Gone are the days when all bets were placed on the rabbit running the fast race and generating the quickest dollar return. We are in "bear country" now. And, we're focusing on the sturdy turtle to run a "sure and steady" race to the finish line. As such, we have included i2 Technologies (ITWO US, $38.1875, CSFB rating: Strong Buy) and CommerceOne (CMRC US, $24.00, CSFB rating: Strong Buy) to our Buy Recommendation list.
As mentioned in our last publication, we had expected the market to head towards the 2300-2200 level (again). For the near-term, we expect Nortel Networks' (NT US, $20.00, CSFB rating: Downgrade to Buy) profit warning to help further dampen market sentiment and push the NASDAQ Composite index lower. For the week ahead, we expect the Composite index to remain depressed but at the same time, we are positive that the downside level of 2200 will hold (potentially strong floor).

Profit warning from NT exacerbated weak sentiment on Friday. NT lowered 1Q01 revenue and EPS estimates to levels well below expectations. The company also brought down full year revenue growth to 15% (from 30%) and EPS growth to 10% (from 30%). NT cited weakening demand for optical systems and circuit-switches due to huge reductions (more than expected) in spending by service providers. We believe NT's woes will continue to adversely impact its stock price performance (upside potential) in the near-term. However, we continue to like NT for the longer-term and recommend a HOLD on the stock (look forward to improved performance in 4Q01 and beyond). As we expect NT's price to remain in consolidation at around the $20.00 level, we recommend investors who own the stock to explore a short-dated NT equity-linked note to compensate for lost performance by capitalising on the stock's recent high price volatility movement.

Europe

Mr. Greenspan's remark that the US economy will not head into a recession and recover quickly stood in sharp contrast to the outlook given by leading technology firms. This does not do any good to this sector and underlines our concerns that a sustainable recovery might take longer than expected. Earnings reports for Q1 will prove to be a major test for markets. In the short-term the current risk-reward scenario is clearly in favour of defensives and selective cyclical stocks. In this respect we would like to highlight the retail, insurance and pharmaceutical sectors. All three sectors managed to recover nicely from the sell-off that occurred early in the year when markets assumed that the worst for the TMT sectors were over. We see a window of outperformance over the next few months on the back of low earnings visibility in the growth sectors. Our top-picks in these sectors are Carrefour, ING and Glaxo-Smithkline.

A stock that we particularly like in this environment is Carrefour (CA FP; EUR 67.85). The stock has come down a long way since its high of EUR 85 in September 2000. The reasons that led to the sharp decline were shop conversions in France and Spain following the Promodes merger and the acquisition of Pryca and Continente, BSE fears in Europe and problems in Argentina. We consider all these factors of short-term nature and believe that they are priced now. After a long period of bad news we expect news-flow to improve over the next few months. Carrefour offers a few points that markets are now focusing on, such as no exposure to the US and high exposure to Europe (85% of EBIT), reasonable valuation compared to its peers and a management with a proven track record. We expect Carrefour to be re-discovered as a top-quality defensive blue chip in the months ahead and reiterate our buy recommendation with a target of EUR 85.

We deleted Deutsche Bank (DBK GY; EUR 95.26) from our recommendation list. After the recent earnings report we see little short-term upside for Deutsche Bank. Valuation is stretched in our view and the announcement of the reorganisation plan contained little news and lowered earnings visibility. Deutsche Bank gained 46.26% since our recommendation in October 1999 and performed very well year-to-date, up 8.48%.

We continue to like the financials and hence we have added Nordea (NDA1V FH; EUR 7.95) to our recommendation list. Nordea is the largest Nordic financial services company with main activities in retail banking (54% of earnings), corporate and investment banking (21%) and asset management and life insurance (23%). Nordea's attraction lies in its low valuation (P/E01 10.9x) and its strong exposure in the rapidly growing life insurance and asset management businesses combined with a robust and highly profitable banking business. We expect the stock to test its old highs close to EUR 9, which leaves an upside in excess of 13% from current levels.

We also added Schneider (SU FP; EUR 69.4) to our recommendation list. A few weeks ago Schneider announced a merger with French competitor Legrand, which would create the world's biggest maker of electrical equipment. 76% of Schneider-Legrand sales is power distribution, i.e. the company manufactures anything that gets electricity from the power plant to the end user. Schneider's focus is mainly on low & medium voltage, which is a higher-growth, higher-margin business. The new company generates 57% of sales in Europe, 29% in US and 14% in RoW (Rest of World). In the US we expect Schneider-Legrand to benefit from the energy crisis as demand for distribution equipment should remain high. Since Schneider & Legrand have a very similar earnings growth and low-cyclical profile we believe the valuation discount (EV/EBITDA01) to ABB is not warranted after the merger. Based on conservative assumptions we expect Schneider to reach EUR 83, which is a 19.6% upside from current levels.

We expect technology stocks to remain volatile in the weeks ahead. We are particularly concerned about last week's downward guidance of US companies such as Nortel, Dell and HP. This might be an indication that the downturn is much more severe and will take longer than expected. With the problems in the telecom sector well known new investments might be further postponed. We now believe that a quick recovery in 2H01 is becoming increasingly unlikely as demand will remain sluggish and inventory adjustments will take longer. Unless we get a quick confirmation where the economy is heading to, hardware stocks could go a bit lower from here in the next few weeks and months even though long-term valuations might look attractive. Hence we would advise to be cautious with new investments but advise long-term investors not to panic now. There is no point in chasing any stock. Setting limits is an appropriate strategy in the current environment of high volatility. Our sector favourite is the IT consulting company Cap Gemini (CAP FP; EUR 199.10).



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