Tech Investing for Luddites

• ByTim Melvin, RealMoney.com Contributor
• On Monday January 12, 2009, 9:02 am EST

There has not been a lot of joy for tech stocks investors so far in 2009. Intel announced that it would fall short of already-lowered forecasts. Microsoft is back below $20 a share and continues a seemingly endless "will they or won't they?" dance with Yahoo! . As we slip deeper into a recession, there will be fewer people willing to step up to purchase a new PC or home entertainment system. Business spending will also slow as companies move to aggressively cut capital spending and protect the bottom line. In a recession, technology profits typically fall off the proverbial cliff as margins are slashed to near zero to generate revenue and keep the doors open. This time is no different. The book-to-bill for the semiconductor industry is below 1, and capital equipment orders were off 28% in the third quarter. Business is bad and likely to get worse for the first half of the year.

I have never been much of a high-tech guy. We have a lot of sophisticated electronics in the house, but it is all my son's stuff. He wired the house for wireless and set up the entertainment system. If it goes beyond the level of the on and off switch, he has to spend an hour or two instructing dear dumb dad on how to use it. My phone has features on it I will never know how to use. I'm lucky I know how to make a call. I have been known to reduce tech support people to either tears or outright laughter.

The same goes for my experience with technology stocks, for the most part. I simply could not tell you which phone, computer or gadget is going to be a success or what kind of multiple to put on that success. There is one kind of tech stock I understand, however. I have done very well buying this type of tech stock over the years. Most of the time, this type of stock simply cannot be found. They only exist after steep market selloffs like we have seen in the past year. I do not have to know how to work my wireless router or surround-sound system to recognize that companies that sell for or near net cash levels with a viable business offer incredible profit potential to a patient investor.

Several situations fit this bill right now. I talked about Adaptec last year, and I still own it. The data storage infrastructure company was profitable in the third quarter and is expected to have a small profit in the fourth. Revenues were down, but restructuring and cost-cutting initiatives have helped turn the bottom line into black ink. The balance sheet is rock-solid, with a little over $3 a share in net cash. I own some here and will buy more if the price gets much closer to that level in future selloffs. As a potential catalyst for pushing prices higher, I note that activist investor Steel Partners owns more than 17% of the stock.

Electro Scientific is another cash-rich company that has felt the impact of the slowdown. The company makes lasers for testing semiconductors as well as machine vision and electronic packaging products to the industry. Despite the tough operating environment, the company has managed to grow revenues by more than 50% in the past three years. Electro Scientific has also been profitable for the last 16 quarters.

The company is expanding its technologies into complementary markets, such as solar and fuel cell micromachining. The soon-to-be-completed merger with Zygo will give the company greater presence in industrial security and medical device markets as well. The company has no debt and a cash hoard that is 80% of the current market capitalization. Activist investor David Nirenberg is a large shareholder, as is Marty Whitman of Third Avenue value funds.

I do not really have to have an in-depth understanding of data storage or semiconductor test equipment to own either of these stocks. It helps to have some idea, but more important to my way of thinking, I am buying viable, profitable companies for only a little more than the amount of cash in the bank. The presence of strong activist investors gives me comfort that management will not simply waste the cash. I am getting the business for close to free, and when the economy recovers, that value will be unlocked. I am not trying to figure out how many routers Cisco will sell in a recessionary environment or which gaming technology will win the day. I am just betting on cash in the bank and an eventual economic recovery.

If I am right about the near-term future of the economy and stock market, there will be more companies that trade near cash levels. As I find them, I will bring them to your attention. As always, buy small. If we are right on these battered beauties, the payoff from even a small position will be rewarding.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider Adaptec and Electro Scientific to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.