TCS Daily


Dubble Bubble?

By James K. Glassman - July 15, 2003 12:00 AM

Is high tech really back, or are we headed for Dubble Bubble?

Whitney Tilson, venerable and circumspect columnist for the Motley Fool, has no doubts: "Times like these make me sigh, hold my head in my hands, and groan, 'How is it possible that, in less than three months, investors seem to have forgotten all of the painful lessons of the previous three years?' " Alas, he wrote those words five weeks ago. Since then, the stocks whose valuations he called "ridiculous" have risen even more. On June 6, the date of Tilson's column, eBay (EBAY), for example, was trading at $96.97 a share and carried a price-to-earnings (P/E) ratio of 69. It closed Friday at $113.07. Similarly, Yahoo (YHOO), which carried a P/E of 84 on June 6, has jumped from $27.95 to $32.19. Microsoft (MSFT) has risen from $23.67 to $27.31.

On May 23, Tilson told readers to sell E-Trade Group (ET), whose shares had soared more than 56 percent in six weeks. They have since risen an additional 46 percent.

My point here is not to ridicule Tilson the way he ridiculed the prices of tech stocks. It is to show what a difficult problem investors face. The tech-heavy Nasdaq composite index has gone from 1271 to 1733 -- an increase of more than one-third -- in four months. It's still nearly 66 percent below its all-time high, set in the spring of 2000. But hasn't it come too far too fast?

Calling precise turning points in markets, or even sectors, is impossible ("The future of security prices is never predictable," the great Benjamin Graham wrote six decades ago). But there are times when Mr. Market -- Graham's personification of the mass of investor sentiment -- gets so pessimistic that he is willing to sell wonderful companies at absurdly low prices. Those prices can go lower, of course, but they should not be resisted.

By last fall, it seemed, to me anyway, that Mr. Market was suffering from a severe case of post-bubble depression. I wrote on Sept. 15, "Investing in high-tech stocks -- the right high-tech stocks -- is an excellent way to take advantage of what [Warren] Buffett calls 'the good news' of a bear market."

The "right" high-tech stocks are the ones that have sound balance sheets, good niches and lackluster competition. They are either making profits already or are on the verge.

I noted that simply hanging on to your shares in bad times is an accomplishment, but, coining an awkward aphorism, I wrote "if you don't buy bananas when they're cheap, you haven't benefited from cheap bananas." Taking the best banana first, I highlighted eBay, then trading around $58 a share.

There were many, many others. At the time, the Prudent Speculator, a newsletter ranked No. 1 by the Hulbert Financial Digest for performance over the past 10 years, was recommending Quintiles Transnational (QTRN), which has since risen 45 percent. OTC Insight, another highly ranked newsletter, had selected another high-tech health care data company, eResearchTechnology (ERES), which has risen 49 percent. I waxed poetic over LendingTree (TREE), which, thanks to a generous buyout, has jumped more than 50 percent.

But that was then. This is now -- a year in which the Philadelphia semiconductor index has increased 38 percent and a typical Internet mutual fund, Munder NetNet (MNNAX), 61 percent.

The sharp high-tech increase is not limited to U.S. stocks. Sina.com (SINA), which operates a Chinese version of America Online, has quadrupled since the start of the year. The German business software company SAP (SAP) is up more than 50 percent. Sohu.com Inc.(SOHU), another Chinese Internet portal, rose 158 percent in June alone.

So, is the amazing comeback of high-tech stocks real or is it Bubblicious?

I think it's real, but we could, as TheStreet.com's James J. Cramer writes, be headed for a "significant tech downturn."

"Expect to do some sweating," Cramer says, but "stay put."

As Graham reminds us, there is no way to predict the short-term movements of stock prices, tech or otherwise. On Thursday, for instance, Yahoo, which had nearly tripled over the preceding 12 months, dropped 8 percent. While Yahoo's price chart is breathtakingly beautiful, nothing goes straight up.

Still, even if this may not be the precisely perfect time to invest in tech, you should not neglect the sector. If you bailed out during the long and sickening slide, you should get back in. Tech, broadly defined, represents about one-fifth of the economy, so it should represent roughly that much of your portfolio -- say, 15 to 25 percent. Go outside those limits, either way, and you are making a market-timing bet that's simply foolish.

But aren't tech stocks overvalued by normal measurements, such as P/E ratios?

Begin with an understanding of "value." The financial-textbook definition is that the proper price for any business is the current value of all the cash the company will earn for its shareholders over its lifetime, discounted by some percentage that reflects the risks involved. The key is future cash flow -- far, far out (though dollars earned in 20 years have a lower value today than dollars earned next month).
If you buy shares in a company today, you don't get the benefit of past corporate achievements, only future ones. Those achievements can't be known today. So we have to make guesses; that's the nature of investing. Part of the basis for those guesses is the company's past performance. But with young technology companies, history can be scanty. As a result, the range of guesses is wide, and so are the opportunities for huge gains or losses.

For a diversified business such as Johnson & Johnson (JNJ), more than a century old, it's not hard to make projections. But what about United Online (UNTD), formed in 2001 from the merger of NetZero and Juno online services, which themselves went public in 1999? United offers free (and paid) access to the Internet for about 5 million subscribers, a business that didn't exist a decade ago. Investors, naturally, have had a difficult time pinning down a value for United. As more information develops -- that is, as the company's history grows longer -- the job of valuation will grow easier.

In 2001, for example, United lost $121 million on revenue of $57 million. The stock crashed from over $100 a share to less than $2. But the next year, the loss was cut to $24 million and the stock rallied. This year, the Value Line Investment Survey expects earnings of $39 million (87 cents per share) and cash flow of about $50 million (about $1.20). The stock trades around $29, so the P/E ratio, based on 2003 expected earnings, is about 32.

Do not, however, take P/Es for such tech stocks too seriously. They are snapshots. They don't reflect the future, which is where a tech company, if it's worth anything at all, will establish its value. For United, Value Line predicts annual per-share earnings of $1.90 between 2006 and 2008 on revenue growth of more than 30 percent a year. But who can know?

United's business plan is to sell free (that is, advertising-supported) or inexpensive Internet access that uses narrow-band telephone-modem connections, rather than more expensive broadband hookups. That's a good niche, with limited competition. United is also using software to boost Internet downloading speeds. Again, that sounds like a good idea -- though one can imagine United being left in the dust if broadband becomes cheaper and if a killer application comes along that makes super-high-speed Internet connections almost a necessity.

In the end, United involves far too much guesswork for my taste, and at these prices its risk-to-reward ratio looks lopsided.

Now consider eBay, the online auctioneer. It's been profitable since it went public in 1998, and it has used the recession and the rough times that have followed to make its position ever more solid. Competitors have melted away, and the cash is rolling in. Revenue has nearly doubled over last year, to $2 billion, and earnings are rising more than 60 percent annually. And eBay keeps coming up with new ideas, such as becoming a marketplace for redeeming frequent-flier points for merchandise.

But is eBay, up 67 percent since the beginning of the year, too expensive? This year, the company will generate about $1.50 per share in free cash flow -- after making the modest capital expenditures in new machines and property that its business requires. In five years, it's not hard to see eBay generating $4 or $5 per share. The firm has nearly $2 billion in cash today, so why shouldn't it start paying a dividend of a buck a share immediately -- at a cost of $300 million -- and $2 or $3 within a few years? (Dividends, I believe, are the wave of the future for tech companies. Investors will demand them, and the new tax law is a massive encouragement.) With a dividend of $2, eBay at today's prices will yield about 2 percent, but that dividend can be expected to rise at 20 percent or more annually for the next decade, doubling every three or four years. In other words, even at $100 a share -- or slightly more -- eBay represents good, though not spectacular, value. Yahoo presents a similar profile, but there may be far better values among tech stocks that are less visible.

Among the possibilities that Jim Collins, editor of OTC Insight, is recommending are Bankrate (RATE), an Internet-based company that provides consumers with information on financial products; FindWhat.com (FWHT), Internet advertising; Network Engines (NENG), server-hardware devices; plus Sina and Sohu and another Chinese online firm, NetEase.com.

Can you find such stocks on your own? It's tough. The best idea is to own a diversified portfolio of techs. Some will be big winners, the way that Dell Computer (DELL), eBay and Microsoft have been; others will be big losers, but on balance you should do well over time. A good tech-stock fund or simply an investment in shares in the exchange-traded fund (ETF) that mimics the Nasdaq 100 index (QQQ) may be the best way to indulge in techs.

You can also choose a more general fund whose manager is not afraid of tech. A good example is Legg Mason Focus (FOCTX), highly rated by both Morningstar -- four stars -- and the top mutual fund newsletter over the past 20 years, No-Load Fund-X. The fund is up 39 percent for 2003.

The top holding of manager Robert G. Hagstrom Jr., as of the March 31, the latest reporting period, is Amazon.com (AMZN), which represents 11 percent of assets. The fund also owns such techs as Microsoft, Vodafone Group (VOD), Nokia (NOK), Computer Associates International (CA), eBay and Yahoo. Hagstrom, by the way, is a follower of Buffett. While Buffett himself eschews tech stocks, he's crazy for value, and that's what techs have provided for nearly a year.

Back in September, I wrote 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."

Right now, investors don't hate tech. In fact, they don't hate much of anything -- except perhaps short-term bonds, whose prices, you'll notice, have been falling. I'm certainly not telling long-term investors to buy short-term bonds. No, the message is to get into technology and stay there. But don't go overboard. You should have done that last fall.
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