Yesterday we posed a simple question in our Monday Update: will valuation matter for Technology stocks in 2011?

As growth stock investors, valuation is not one of our primary inputs -- Relative Strength, fast top- and bottom-line growth rates, margin expansion, and the ability to beat consensus are the primary data points that we concern ourselves with. This strategy of focusing just on the fundamental drivers and setting aside valuation would have generated excellent returns in the second half of 2010, and likely would have kept you invested in at least a few of the "Four Horseman" of the Emerging Growth Stocks universe: Acme Packet (APKT), Netflix (NFLX), F5 Networks (FFIV), and Riverbed Technology (RVBD).

However, we are also aware that stretched valuations are also a proxy for extremely high expectations, which means that companies that sport rich multiples over an extended period of time (6-12 months or more) have very little margin for error when it comes meeting the Street's expectations.

Since we have such a strong Relative Strength bias, this leads us to the more pertinent question: will rich valuations become an impediment to continued outperformance in 2011? This is of course unknowable at the present, but we do know from Kirkpatrick's statistical study of Relative Strength that while a very small handful of stocks may outperform the market for long periods of time, the predictability of returns for high-RS stocks tends to decay the longer the holding period. Specifically, starting with a universe of top-ranked stocks based on prior 6-month RS, he found that the subsequent 3-month period showed the greatest returns, the subsequent 6-month period had very good returns (but at very high RS levels performance flattened out), and the subsequent 12-month period showed widely varying returns and had little predictive value. 

It is this "time" risk associated with high-RS stocks, combined with stretched valuations, that makes us nervous about the elite Technology stocks that performed so well for us last year. If you already have positions in them at favorable prices, then they should continue to be core Technology holdings until one of them stumbles. But given their parabolic runs in 2H10, an extended consolidation period for 2010's biggest winners in the new year is also not an unreasonable assumption.

We know we want to stay invested in the Technology sector due to the multi-year network upgrade cycle occurring there, but at this stage of the bull market we think it's prudent to diversify our bets with some new, smaller, and more reasonably priced growth ideas.

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In the table below, you'll find the leading Technology stocks from both of our Emerging Growth and Stocks Under $10 lists, sorted by Forward P/E (which for most companies will be FY11). As you can see, the table is segmented into two parts: the "Four Horsemen" of APKT, NFLX, RVBD, and FFIV; and "Everyone Else".

The data for APKT, NFLX, RVBD, and FFIV are pretty clear-cut: on an absolute basis those are just expensive P/E and P/S ratios, as befits their best-of-breed status. On the other hand, the PEG ratios for all four remain squarely in the "fairly valued" category (between 1.0 and 2.0), and nowhere near the "expensive" or "egregiously overvalued" ranges (above 2.0). Herein resides the primary bull argument for these stocks in terms of valuation: since all four companies have been consistently guiding higher over the course of 2010, and this trend is expected to continue into at least the first half of 2011, then it's fair to assume that those estimated growth rates are too low, thus making the "real" PEG ratios less expensive than they currently appear.

It's in the "Everyone Else" category that some interesting ideas pop up. Particularly, what we're looking for are companies with reasonable absolute P/Es, estimates for strong EPS growth to continue into next year, and ideally a lot of cash on the balance sheet. Not surprisingly, almost all of these companies are tied to the network upgrade cycle sparked by the proliferation of smartphones and tablets.

Here are the names that we find most compelling in this regard, in order of their appearance on the table:    

Opnet Technologies (OPNT)
On an absolute basis this is the most expensive of our picks, trading at 33x estimated FY11 EPS, but earnings are expected to grow 42% next year, for a PEG of 0.8x. Yet the reason why we find this one attractive is that the company has a ton of cash (19% of its market cap) and it sells into the networking end market. Specifically, OPNT provides network management software applications used for designing, building, and operating networks. Its software lets designers evaluate how networks will perform under simulated conditions, analyze collected data, and resolve performance problems such as poorly designed applications, network configuration errors, network congestion, inefficient use of the network by applications, application bugs, and database inefficiencies. Customer verticals range from enterprises, government departments, network service providers, and network equipment manufacturers.

Allot Communications (ALLT)
This is a similar case as above: ALLT may sport an expensive P/E of 30x, but since earnings are expected to grow 98% next year the PEG is actually quite cheap at 0.3x. Moreover, ALLT's cash balance makes up 27% of its market cap (which fits into the micro-cap category at just $207 million). This company is a play on the insatiable need for more network bandwidth, and more particularly the proliferation of smartphones. ALLT builds systems that help service providers optimize their networks. Its NetEnforcer bandwidth management hardware and NetXplorer software help control and improve network performance. Together the systems prioritize and reroute Internet traffic, increase bandwidth, balance server loads, and monitor network performance. The vast majority of ALLT's revenue growth has come from the mobile market, as the rapid proliferation of data-hungry smartphones has driven demand for faster and more reliable networks.

Anadigics (ANAD)
A play on the increasing use of smartphones, ANAD trades at a fairly-valued absolute P/E of 26x, but this seems very reasonable in light of the company's estimated 190% EPS growth rate for FY11. Also, 17% of ANAD's $514 million market cap is cash. ANAD makes radio-frequency integrated circuits for wireless handsets, set top boxes and fiber-optic equipment. Its two key markets are wireless (68% of revs) and broadband (32%). ANAD is a play on the increasing use of smartphones because they require higher performance power amplifiers like the ones ANAD sells. ANAD is also benefitting from increasing shipments of WiFi-enabled devices, which use multiple power amplifiers. The company is also well positioned for the rollout of the 4G LTE market.

Ixia (XXIA)
XXIA has been one of our favorite stocks since we included it in our July 29 "Six Tech Stocks That Could Be Attractive On A Pullback" piece. While the stock has run 70% since then, it still isn't overvalued yet, with a reasonable P/E of 24x and a PEG of 0.5x (FY11 EPS is expected to grow 53%). The company has a decent amount of cash, at 7% of its market cap. XXIA makes hardware and software for network equipment manufacturers and service providers that tests and measures the performance and service quality of wireless & wired IP equipment and networks. The company is benefitting from two main catalysts that are creating great demand for sophisticated test & measurement systems: 1) the convergence of Ethernet and Fibre Channel as well as the consolidation of server assets through the use of virtualization; and 2) telecom carriers' need to upgrade their networks from the current 2.5G and 3G networks to 4G.

Alliance Fiber Optic Products (AFOP)
AFOP trades at 16x estimated FY11 EPS, which looks cheap when you consider that earnings are expected to grow 21% next year, making for a PEG of 0.8x. Even better, AFOP has a fantastic balance sheet, with cash accounting for 35% of its market cap. The company is another play on the incredible demand for more bandwidth that is being fueled by advanced streaming services as well as the proliferation of smartphones and tablets. The company sells fiber optic components and integrated modules to network equipment manufacturers. Until recently, most of the fiber deployed had been dedicated to long-haul networks. However, the demands for high-speed network access are shifting the focus towards more the metro networks and last mile access networks, which require an increasing number of connections and components. Essentially, existing metro network infrastructure has become a bottleneck, and this has created a new network upgrade cycle that benefits fiber optic component makers such as AFOP.

Netgear (NTGR)
NTGR is a very reasonably priced growth story, trading at 16x next year's earnings, and with a PEG of 0.8x (EPS is expected to grow 21% next year). The company also is cash-rich, with 20% of its market cap consisting of cash and equivalents. A successful turnaround story in recent years, NTGR designs a range of computer networking equipment including hubs, routers, switches, media servers, and wireless controllers for home users and for small businesses. The company also supplies network-attached storage (NAS) systems, VPN firewalls, and digital media receivers. NTGR has achieved a dramatic turnaround in its consumer business, and has particularly benefited from the wireless transition to the new 802.11n standard, which improves security and versatility over a wireless local area network (WAN).

Entropic Communications (ENTR)
ENTR is expected to grow EPS 40% in 2011, yet only trades at 16x forward earnings, with a PEG of just 0.4x. Why such cheap multiples? In a word, competition. First of all, ENTR sells semiconductors used in devices that allow consumers to network DVRs, cable set-top boxes, Blu-ray players, gaming consoles, and computers. A big catalyst for the stock has been the ability to record a TV show on a DVR in one room, and watch it in another room on a different TV. This is a service that is just starting to be rolled out by the major service providers. The primary concern with ENTR has been that it was just a matter of time before its rival Broadcom (BRCM) would mount a serious challenge to its dominance in this market. However, a bullish presentation at an investor conference on December 2 seems to have allayed those fears (for the time being, at least).

Newport (NEWP)
NEWP is a cheap play on the recovery in industrial markets, trading at just 14x estimated FY11 EPS and with a PEG of 0.7x. EPS is expected to grow 19% next year, and the company has a ton of cash, at 26% of its market cap. However, NEWP does have a high debt level, with LT Debt/Capital ratio of 30%. The company is a producer of lasers, photonics instrumentation, sub-micron positioning systems, optical components, and subsystems. It makes more than 15,000 products serving a wide variety of industries including scientific research, aerospace/defense, microelectronics, life sciences and industrial manufacturing. Following some weak results last year, Newport has been posting much stronger results over the past few quarters as it benefits from the overall recovery in the industrial market. In particular, its microelectronics business is doing exceptionally well as the company is seeing robust order activity from tier one semiconductor equipment customers.

AXT Inc (AXTI)
AXTI is a cheap play on the upgrade cycle in mobile networks and handsets, as well as the LED market. The stock trades at just 12x estimated FY11 EPS and at a PEG of just 0.6x, with EPS expected to grow a robust 19% in 2011. The company also has a lot of cash, at 10% of its market cap. AXTI is a producer of semiconductor substrates, mostly gallium arsenide (GaAs) but also emerging substrates such as indium phosphide (InP) and germanium (Ge). These are considered higher performance substrates than conventional silicon substrates, and are used in smartphones, LED lighting, and solar cells. AXTI is benefiting from the upgrade cycle for 3G-enabled phones, which require a heavy content of GaAs to support enhanced performance and feature sets. AXTI expects this cycle will continue for quite some time, as the worldwide rollout of 3G and 3G+ networks is still ongoing, and wireless carriers are just starting to roll out their 4G (LTE) networks, which is in turn expected to begin another upgrade cycle to 4G phones that will have even greater functionality and GaAs content than the previous generation.

LeCroy (LCRY)
LCRY is a cheap (10x estimated FY11 EPS), lesser-known play on the explosive rise in data-hungry smartphones and tablets, which is forcing service providers to substantially upgrade their networks. These devices require high speed data exchange not only connecting to towers but over the long haul network as well. Right now, the current interface standard is 10G, with 30G already being rolled out and 100G expected to be introduced soon. LCRY benefits from this cycle because its oscilloscopes (graphical display devices that are used to design electronic equipment) are seeing huge demand as R&D departments upgrade their oscilloscopes as they design new 30G and 100G devices. Further, it is especially encouraging that the company's high-end, high-margin products are doing especially well. The CEO described the company's fundamental picture best during the last conference call, when he described demand as "stunning." That last quote suggests that the current FY11 EPS growth estimate of +11% could be very conservative. See our October 15 report on LeCroy for more details on the story.

Web.com (WWWW)
WWWW trades at low multiples of 9x estimated FY11 EPS and a PEG of 0.2x for a good reason: it is an ongoing turnaround story. For much of its history WWWW was provider of website design tools and services to small- to medium-sized corporate customers, which was a hypercompetitive and commoditized business where deals were won mainly on price. Yet the June 17 acquisition of domain name registrar Register.com was a turning point, as the deal effectively quadrupled WWWW's subscriber count, opened up significant cross-selling opportunities, and greatly enhanced Web.com's lead generation (i.e. "I see that you registered a new domain name, would you like us to build and maintain your website?"). More importantly, it also led management to almost double its 2011 EPS guidance to $1.00/share (analysts now expect FY11 EPS to grow +59%). Even more promising, management only expects to realize approximately half of the potential cost synergies from the deal during 2011, meaning that the realized cost savings are expected to double from 2011 to 2012. In other words, even if sales continue to grow at just a modest rate, this company will have a huge amount of EPS leverage lasting another two full years.     

Conclusion

This list should provide growth investors plenty of ideas to work with as the new year begins. All of these companies are currently ranked on one of our two lists, so they already feature strong Relative Strength and healthy growth rates.

As always, consider these ideas to be starting points for your own research, since everyone has their own holding periods and degrees of risk tolerance. Once you complete your own due diligence and find an idea you like, we would recommend buying these types of names during one of the periodic bouts of profit-taking that hits the Tech sector every few weeks, rather than during breakouts.    

-- Jim Busch