Cashing in on TECH STOCKS.

They may have tremendous potential, but how do you tell the difference between a sure thing and a pipe dream?

AUDRAY McMILLIAN HAS BECOME WIRED INTO TECH stocks. After watching share prices for myriad issues soar to phenomenal highs, he just couldn't resist expanding his holdings in these companies. "Tech shares offer some of the best opportunities around," he asserts. "You can only imagine that there are millions of e-mails sent every day, and that as popular as computers are, there still isn't one in every household or even classroom. To me that means the market for products like these has plenty of room to grow."

With the help of his financial planner, the 36-year-old Houston real estate developer has reprogrammed his $150,000 retirement portfolio by purchasing large positions in tech stocks, including such notables as Compaq (NYSE: CPQ), the manufacturer that posted gains of roughly 200%, and Cisco Systems (Nasdaq: CSCO), a computer networking company that grew 143% by late December.

McMillian is among the growing number of investors who are seeking to cash in on the technology boom. From companies that provide access to the Internet to manufacturers of laptop computers, this sector represents the greatest force propelling the stock market today. We get sweaty palms at the mere mention of such companies as America Online (NYSE: AOL) and Amazon.com (Nasdaq: AMZN). And with good reason. Last year alone, AOL produced a mind-boggling 361% gain while Amazon. com was up a staggering 900%.

But technology has proven to be the most volatile of sectors. On January 6, the Dow cracked the 9500 level as stocks surged 233.78 points--the seventh largest point gain ever. The charge was led by tech stocks. A week later, on January 13, the market dropped 125.12 points, due to the devaluation of Brazil's currency. Such hot internet-related stocks as Amazon.com, Broadcast.com and eBay dropped 8%, 14% and 26%, respectively in one week.

So just how in the world do you figure, out what makes these stocks move? To most of us, the talk of Internet protocols, software upgrades, wafer boards and next generations is enough to make us feel like Fred Flintstone hurled unceremoniously into the world of the Jetsons.

The simple fact is this: technology shares just aren't measured like other stocks. Many software, hardware, semiconductor or Net shares don't fit the neat understandable price-to-earnings (P/E) multiples that we've learned to use as a guide to making stock purchases. And shares aren't cheap: AOL has a stock price about 280 times earnings, at a time when the Standard & Poor's 500 fetches a P/E of only 20.

Investors are banking on future earnings growth and, as a result, have bid share prices to astronomical levels. But you can just as easily find sad tales of individuals who have bought a speculative issue and seen their investment evaporate at the first sign of crisis.

Still, the right mix of tech stocks will offer you highly charged returns. Even with the turbulence experienced in the market, the sector had a banner year in 1998. As of mid-December, in fact, the Pacific Stock Exchange Tech Index, the barometer for the technology sector, was up 40%, outpacing the 18% return for the S&P 500.

You can find-a way, however, to plug into tech stocks and produce maximum gain with minimal risk. BE suggests that you take a long-term view: Find those that have withstood the test of time as you create a sound investment portfolio.

MEASURING STICKS

We talked to a group of experts to let you know the best method to sniff out winners. First, you need to figure out how to value technology stocks. For most companies, you examine the earnings per share, the manner in which Wall Street divvies up a company's profits to shareholders. After assessing how quickly or slowly earnings are growing, you then compare the company with the broad market by looking at the PIE multiples--the share price divided by its earnings per share. To gauge whether the stock is indeed a bargain, you'd compare that figure with the P/E of the S&P 500 or Dow Jones Industrials.

Portfolio managers use the same yardstick for tech issues, but differently. Since investment pros have found that tech companies can grow earnings faster than retailers, financial services firms or industrial companies, their shares stand a greater chance of appreciating over time. Because of that ability to increase value, tech shares are allotted a higher multiple in the market.

A good example is Cisco Systems. Wall Street analysts believe that the computer networking company is slated to increase earnings at close to a 30% clip over the next five years, according to Zacks Investment Research. That figure significantly dwarfs the S&P's projected earnings growth rate of 7% over the same period. Since Cisco's shares will stay in high demand, the company's shares trade at a P/E of 75 instead of 22, the market average. Because of this factor, money managers tend to use P/E multiples to differentiate stocks in the same industry since they face similar competitive challenges.

To figure out how much a company's projected growth is worth, money managers use a tech company's P/E multiple and measure it against its projected growth rate. According to Michael T. Manns, a senior portfolio manager who oversees $800 million in institutional funds for American Express Asset Management, a technology stock looks more attractive as long as the P/E is no more than 1.5 times its growth rate. If the stock is above that figure, then chances are the stock's price, is too high. Below that point, you've snagged a bargain.

One final barometer is the price-to-sales ratio. To figure this measure, you multiply a company's stock price by the number of shares, and then divide the figure by its sales. This technique--used chiefly to gauge competitors within the same industry--has been applied to evaluating emerging firms that remain a major force in their industry but have yet to produce a earnings stream. In this case, money managers believe that sales are a good indication of what's to come. C. Kim Goodwin, portfolio manager for the $6.6 billion American Century Growth Fund, maintains that "the way a lot of these tech companies are going to fuel earnings is by accelerating the top line."

FOLLOW THE LEADERS

If you're like many investors, you're probably salivating over the prospects of investing in some hot Internet stock. In January, a number of such companies--namely, Amazon.com, Yahoo! and E*Trade--either announced or considered stock splits to make their shares more affordable to individual investors. This action, in turn, further bid up prices for these companies. One caveat: these stocks, many of which are not backed up by solid earnings growth, will be the first to be hit in a market rout. So don't be surprised if your investment takes periodic dips.

We suggest that you stick to companies that dominate their industries. New issues such as Net stocks have produced amazing returns, but can drop just as quickly. For cautious long-term investors, the best course is to purchase shares of the tried and true. Such examples include Intel, the mammoth semiconductor manufacturer that controls roughly 90% of the market, or a giant like Microsoft, which has a virtual stranglehold on operating software for personal computers. When the market dropped after the Brazilian currency devaluation, these two stocks proved to be among the most resilient.

Start with the fact that the monoliths usually push the direction of their market, and maintain deep-rooted customer relationships. Moreover, they have the ability to fend off or acquire smaller competitors. Money managers like American Express' Manns will buy these concerns even though the P/E multiple is higher than the growth rate. Over time, he believes the value of shares will surge as these concerns merge with other entities.

In an era when today's tech darlings can turn into dogs overnight, the leaders provide you with stability because of their staying power. This will become very important if the stock market has the same volatility that it displayed in 1998.

TODAY'S STARS

So, which companies are the stars of the tech sector? Below, we have identified the best buys in each segment and the reasons you may want to invest in these issues. They include the following:

INTERNET

   LEADER: AMERICA ONLINE (NYSE: AOL) Honorable Mention: MCI-Worldcom (Nasdaq:
   WCOM)

Internet stocks have been some of the hottest shares around in 1998. The reason: the World Wide Web looks to be as much a communications breakthrough as the telephone. In fact, it's estimated that online traffic is doubling every three months.

The explosion of the Internet has certainly taken the stock market by storm. It's hard to gauge the overall impact; S&P doesn't chart the group by an index, but instead lumps it together with computer software and services. Nonetheless, that group, which includes Net stocks, had risen almost 65% in 1998.

Without a doubt, the group leader is AOL, the No. 1 Internet access provider. The company's profits are currently in the black, and analysts predict it will grow earnings at an average 48% annually over the next five years. At press time, all 32 Wall Street analysts who cover the stock rated it a "buy."

Another way to play the boom of the Internet is through long distance carrier MCI-Worldcom. The company may play second fiddle to AT&T when it comes to reaching out and touching someone, but it's a bona fide leader on the World Wide Web, owning approximately 50% of the Internet's network. In other words, when you log onto AOL your communication in chat groups and online shipping goes through MCI Worldcom's infrastructure.

MCI Worldcom is rated a "strong buy" or "buy" by 32 of the 34 analysts that cover the stock on Wall Street. The company is predicted to grow earnings about 30% annually over the next five years.

COMPUTER NETWORKING

   LEADER: CIsco SYSTEMS (NASDAQ: CSCO) Honorable Mention: Lucent Technologies
   (NYSE: LU)

Think of computer networking as the surefire way to bet on the Internet. That's because corporations and phone companies will likely suspend billions on the networking equipment designed to help companies plug into the biggest network going: the Web. That kind of demand, by some estimates, should help the computer networking sector grow sales by 30%-40% a year.

Leading the pack is Cisco Systems, a company whose market share hovers around 70%. Wall Street has the utmost confidence in Cisco's continued dominance. Analysts believe the company can grow earnings by 28% annually over the next five years. That was enough to convince all 30 Wall Street analysts who cover the stock to rate it a "buy" or "strong buy."

Lucent Technologies is another name you might want to look at. Formerly AT&T's research and equipment manufacturing arm, Lucent is the leading maker of equipment phone companies from coast to coast use to keep everyone in touch. But now that the worlds of computer networking and telephone communications are colliding, Lucent has been busy snatching up companies such as the proposed $20 billion acquisition of Ascend Communications, that will help it better compete with Cisco. Wall Street projects Lucent to grow earnings by 22% annually over the next five years, and of the 29 analysts that follow the company, 17 rate it a "buy" or "strong buy."

SOFTWARE

   LEADER: MICROSOFT (NYSE: MSFT)

Next year might not be the best time to bet on software stocks. With the ominous Year 2000 bug likely to plague most corporate heads, software sales are expected to drop. One segment that will chug along with nary a problem in sight, though, is operating software, a product synonymous with one name: Microsoft.

Microsoft has had its share of woes in 1998, grappling with federal investigators who claim that the company has gone out of its way to thwart the competitors. And, true enough, the government might beat Microsoft and pin an antitrust rap on the software king, but that's no reason for you not to join Bill Gates & Co. For one thing, says American Century's Goodwin, Microsoft expects to beat an antitrust rap on appeal. It has a virtual lock on the market--some say as much as 80%. That's in part why Wall Street thinks the company will grow earnings at an average annual rate of 24% over the next five years. Microsoft is rated a "buy" or "strong buy" by 22 of the 27 Wall Street analysts who follow the company.

SEMICONDUCTORS

   LEADER: INTEL (NYSE: INTC)

Semiconductor makers had a rough 1997 and first half of 1998. First, Asia's economic malady hit. Then, there was talk that cheap PCs would hurt revenues. By the year's end, though, demand for computers started percolating.

That was very good news, indeed, for Intel, the company that rules the silicon wafer roost with a 90% plus market share. Long-term prospects look good, too. Estimates are that semiconductor revenues should hit $220 billion a year by 2001, up from $137 billion in 1997. That has Wall Street convinced that Intel should average annual earnings growth of 20% for the next five years. Of the 35 analysts who cover the company, 26 have rated it a "buy" or "strong buy."

COMPUTER HARDWARE

   LEADERS: DELL (NYSE: DELL); COMPAQ (NYSE: CPQ)

PCs are perhaps the most visible component of the technology revolution, but the sector has been a sore spot for investors. There have been concerns that demand in Asia had shrunk and that low-cost desktops were sawing away at industry revenues.

Manns says the sector will continue to be promising in the long run. For one, PC demand has firmed up and pricing seems relatively stable. Meanwhile, industry leaders Dell and Compaq have been busy expanding their reach into new areas such as servers, computers that act as the backbone of in-house office networks. Currently 20 of 30 Wall Street analysts who follow Dell rate it a "buy" or "strong buy." They expect the company to grow earnings at a rate of 30% a year over the next half decade. Compaq is rated a "strong buy" or "buy" by 20 of 34 analysts who cover it on Wall Street. It is projected to grow earnings an average of 19% per year over the next five years.

So, if you are like Audray McMillian and see technology stocks as a larger part of your portfolio, consult your financial planner, conduct the research and, if you are not the adventurous sort, stick with established firms. That will keep you from short-circuiting your long-term investment strategy.

RELATED ARTICLE: Still Overwhelmed? Tech Funds Might Be Your Best Bet.

Maybe tech stocks still give you the jitters. If you don't have the time to research every last Internet stock on earth or want to own slices of different technology companies, whether they're monoliths or up-and-coming dynamos, consider buying technology sector funds.

Technology sector funds function like other stock mutual funds. They provide you with a professional money manager who invests in a range of different tech companies. Like other sector funds, these vehicles limit their holdings to a few industries, including computer hardware, software, networking, Internet and communications equipment firms.

You should still be on guard, though. Tech funds are confined to a narrow--and volatile--market and don't benefit from the cushion from other sectors. That means when computer and Internet shares are red hot, tech funds will very likely be on fire. And when shares fall, your tech fund is likely to get scorched.

To help you come up with a few investment picks, BE called on Morningstar, the Chicago firm that tracks the mutual fund industry, to screen no-load funds with three-year track records. This will give you the best idea of funds that best weathered the ups and downs of the market.

The leaders are Firsthand Technology Value Fund (888-884-2675), which has an average annual total return of 23.45% for the last 36 months and its cousin, Firsthand Technology Leaders, which was up a whopping 72%. However, the funds are pricey; the minimum initial investment is $10,000 for these no-loads. The two funds were designed for high net worth individuals and institutional investors. For tech funds that offer less expensive initial investments and high returns, see chart, "Tech Funds to Plug Into."

--J.A.A.