TCS Daily


Shopping for Opportunities

By James K. Glassman - September 17, 2002 12:00 AM

If the current bear market hurts, it should. It's the fourth-worst in modern market history. But here's balm for aching portfolios: The smart folks at Sanford Bernstein & Co., a value-oriented investment-management firm, tell us that "the key thing to remember is that companies retain their assets, earning power and ability to grow even when stock prices plunge, but now you can buy all this for less than before."

Warren Buffett put it this way in the 1996 annual report of Berkshire Hathaway Inc., the company he chairs: "Long-term shareholders benefit from a sinking market much as a regular purchaser of food benefits from declining food prices. So when the market plummets - as it will from time to time - neither panic nor mourn. It's good news."

Good news, yes, but falling markets help only those investors who actually buy shares of stock during the bad times. Simply riding the market down and then up again may be a noble achievement, but if you don't buy bananas when they're cheap, you haven't benefited from cheap bananas. Also remember that not all companies have the "assets, earning power and ability to grow" to which the experts at Bernstein refer. Don't buy rotten bananas, even in a bear market.

Which brings me to technology. In the past 2 1/2 years, the Nasdaq 100 index, which reflects the performance of the largest companies on that tech-heavy market, has lost 80 percent of its value. Interactive Week's Internet index is down 50 percent this year alone. And Sun Microsystems Inc. (symbol: SUNW), widely admired in boom times, has fallen from a market capitalization (value according to investors) of $200 billion in 2000 to $10 billion today.

Sun's price has declined because its real-life performance has declined. For the fiscal year that ended June 30, revenue fell by one-third, and the company suffered a loss of $600 million, compared with a profit of $900 million in 2001. Sun, which makes computer servers and workstations and developed the Java programming language, may yet recover, but there are many high-tech companies whose stock prices have suffered in this bear market but whose profits have actually increased. Despite all the gloom and doom, many techs are making money -- in some cases, lots of money. Investing in high-tech stocks -- the right high-tech stocks -- is an excellent way to take advantage of what Buffett calls "the good news" of a bear market.

Consider the best first: EBay Inc. (EBAY), the online auctioneer, profitable ever since it went public in 1998. EBay continues to dazzle. In the most recent quarter, the company's revenue rose 66 percent, to $235 million, and net income (i.e., profit) more than doubled, to $54 million. The Value Line Investment Survey, which awards a rating of "1" (tops) to the stock, estimates that eBay's annual revenue will rise to $1.4 billion next year and that net income will hit $345 million, for a profit margin of an incredible 25 percent. EBay has $723 million in cash and just $28 million in debt. In July, the firm announced it would use some of its shares to buy a wonderful company, PayPal (PYPL), whose 13 million subscribers use its service to transfer money by e-mail or cell phone. PayPal is a modern Internet bank, and eBay, with 50 million registered users of its own, will shortly own it.

Unlike most stocks, eBay has been stable this year, bouncing around most of the time between $50 and $60 a share (it closed Friday at $58). Investors who bought the stock four years ago have made a profit of about 1,500 percent, but eBay still trades well below its all-time high of $127, reached in early 2000. EBay has superb management, a great product that has strong appeal in good times and bad, an excellent balance sheet, and terrific fundamentals. What's wrong? Well, it isn't cheap. EBay is expected to earn about 80 cents a share this year and $1.10 or so in 2003. Figure it out: That's a price-to-earnings (P/E) ratio of between 50 and 70, more than twice as high as the average stock. On the other hand, eBay is growing six times as fast as the average stock, and it's still in the childhood stage of its business life.

Want something cheaper? A smaller Internet stock that's also impressively profitable, but more speculative, is Overture Services Inc. (OVER), which invented a new marketing system called "pay-for-performance": Its 67,000 advertisers pay Overture only when interested consumers click on their sites. The company earned $20 million on $288 million in revenue last year, and Value Line projects a profit of $90 million on $645 million in revenue for 2002. Trading at $22.78 on Friday, Overture's P/E ratio, based on this year's estimated earnings, is just 14.

Overture was one of 20 Internet companies, both profitable and rated "buy" or better by analysts, that were cited in a Sept. 2 article in BusinessWeek highlighting "smart buys . . . emerging from the Net's ruins" (a bit of hyperbole there: The Net is not in ruins; far from it). Also of interest on the list: LendingTree Inc. (TREE), which offers online loan comparisons and has boosted its revenue from $7 million to $64 million in two years, and Alloy Online (ALOY), a direct-marketing service targeted at the 60 million Americans aged 10 to 24. Alloy is only recently profitable (LearningTree is profitable only in a "pro forma," rather than a strict-accounting sense), but its revenue rose 81 percent in the most recent quarter, and it has snagged clients such as Johnson & Johnson, Citibank and PepsiCo.

A more traditional choice is Cisco Systems Inc. (CSCO), which, writes Michael Murphy in his California Technology Stock Letter, "continues to dominate the router market." In fact, its share of this key hardware sector has risen to 61 percent. That's what happens in a recession. Firms like Cisco may lose sales, but they have strong enough balance sheets to keep up their research and capital investment in tough times, while weaker competitors drop out.

Cisco has $13 billion in cash and short-term investments, no debt, revenue of $19 billion for the year ending in July and net earnings about $2 billion. On the other hand, Cisco's sales and profits could be flat for a while. But investors know that, and they have driven the stock down from a high of $82 in 2000 to just $13.05 on Friday.

If you had bought 100 shares of Cisco when it went public in 1990, you would have, through splits, 28,800 shares today, with your original stake increasing nearly 100-fold. But practically anyone who has bought Cisco since 1998 has been a loser. Will Cisco get even cheaper? No one knows, but Murphy considers the stock a good buy up to a price of $16. While Cisco has been consistently profitable over the past decade, it has never made more than 53 cents a share, and it's now making about half that. Still, when the telecom and computer sectors recover, Cisco should be the leader.

What about Intel Corp. (INTC)? I have never been a fan of huge semiconductor manufacturers, because they have to plough too much of their cash back into new plants and equipment. Last year, for example, Intel's cash flow was $7.8 billion, but its capital spending was $7.3 billion.

While a chart of the price of Cisco stock tumbles downhill, a chart of the price of eResearch Technology Inc. (ERES) rises at a 45-degree angle. The company provides software and consulting services to help streamline the clinical trials that drugs and medical devices have to pass before they go to market. The firm graces a list of just 12 "exceptionally attractive stocks" selected by Jim Collins, whose OTC Insight, based in Walnut Creek, Calif., ranks No. 1 over the past 15 years among newsletters monitored by the Hulbert Financial Digest.

Collins does not like many tech stocks these days -- one of the few is Neoware Systems Inc. (NWRE) -- but he's a big fan of eResearch. Shares have quadrupled in value in the past year. And no wonder: Revenue is rising at a 40 percent clip, and for the first six months of 2002 profit was about $2 million, compared with a loss of $5 million for the same period in 2001. On the modest assumption that the company will earn 60 cents for the year ahead, it's trading at a P/E of around 30. But beware: This is a tiny business, with a market cap of less than $200 million (compared with about $100 billion for Cisco).

By the way, a much larger company in the same sector, Quintiles Transnational Corp. (QTRN), is a recommendation of the Prudent Speculator newsletter, which Hulbert ranks No. 1 over the past 10 years. In contrast to eResearch, shares of Quintiles have fallen by half over the past year, making the company a more typical bear-market stock. Both firms reflect an important theme in difficult times: They have a clear niche in a part of the economy (health care) that should grow substantially over the next 20 years.

While technology stocks represent about 15 percent of the total market cap of the benchmark Standard & Poor's 500-stock index, most diversified mutual funds have been avoiding the sector like the plague. Fidelity Contrafund (FCNTX), which I ranked No. 1 last week as a long-term core fund, has only 5 percent of its assets in tech, and even highly regarded Baron Small-Cap (BSCFX), an aggressive growth fund, has just 3 percent. The talented William Miller, manager of Legg Mason Value Trust (LMVTX) and a tech booster in the recent past, gives tech a weighting of only 7 percent, but he continues to hold a big chunk of Amazon.com Inc. (AMZN), a stock I like as well. Amazon, which is expected to make a profit next year, has tripled off its low of 2001, but it's still down 90 percent from its high of 1999. Miller has only two other tech stocks among his top holdings: AOL Time Warner Inc. (AOL) and International Business Machines (IBM).

But I was happy to see that Babson Growth (BABSX), a true contrarian fund, has moved heavily into technology. The sector now represents 23 percent of Babson's assets, and the fund's top 12 holdings include three specialized microchip makers, Maxim Integrated Products Inc. (MXIM), Analog Devices Inc. (ADI) and Linear Technology Corp. (LLTC). Another contrarian, Bob Torray of the Torray Fund (TORYX), has 19 percent of his assets in techs, including Hewlett-Packard Co. (HPQ), which, after its merger with Compaq Computer Corp., makes an enticing choice.

I will admit that mustering enthusiasm for tech stocks today is not easy. But that's the point. When investors hate an industry, it tends to offer good value. And, as the Bernstein analysts put it, "As an investor, you want to buy low, and a bear market presents a classic opportunity to do so." For technology, the opportunity is classic in the extreme.
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