TCS Daily


It's Not the Late '90s

By James K. Glassman - November 6, 2003 12:00 AM

The cover of the latest Business 2.0, one of the few surviving techie-financial magazines of the go-go 1990s, issues a dire warning:

"Why This Tech Bubble Is About to Blow," screams the headline. And the subhead: "Wall Street Is Doing It Again . . . Save Yourself!"

It's nice to see one of these normally boosterish publications advising caution, but is it true, as the magazine claims, that "tech stocks are back to dangerously inflated levels" and that "sadly, there's only one way this can end"?

I don't think so. Certainly, it's unwise to overload your portfolio with tech stocks or to chase companies with foolish business plans. But it's also unwise to reject tech just because prices are rising. Yes, it would have been more profitable to buy EarthLink Network (ELNK), the Internet service provider that was a recent recommendation of the conservative Value Line Investment Survey, nine months ago at roughly half its current price. Duh. But such stocks should not be shunned simply because other investors have started buying them again.

On March 16, I marked the third anniversary of the peak of the tech-heavy Nasdaq composite index by asking the opposite question from the one posed by Business 2.0: With tech stocks having lost about three-quarters of their value, why would anyone ever want to own them again? "Past is past," I wrote, but "what about the future of tech stocks?"

I was enthusiastic, citing Novell (NOVL), maker of Internet-based business software, which has gone from $2.24 to $5.66; Apple Computer (AAPL), personal computing and music, from $14.78 to $23.09; and eBay (EBAY), the online auctioneer, from $41.96 to $56.65.

At the time, I lamented the fact that so many tech mutual funds were diversifying into non-tech stocks or cowering with piles of cash. I cited only one fund that met my criteria: Dreyfus Premier Technology Growth (DTGRX). It was flat for the first three months of the year but since has risen more than 50 percent. The fund's top holding, UTStarcom (UTSI), a wireless-equipment maker that concentrates on the China market, is up 74 percent since mid-March. The next leading assets, in order, are: Dell Computer (DELL), up 38 percent; Cisco Systems (CSCO), up 57 percent; Intel Corp. (INTC), up 94 percent; and Taiwan Semiconductor Manufacturing (TSM), up 66 percent.

Frankly, however, it was awfully easy to be wild about tech stocks in March, when they were so beaten up. All you had to do was believe that the economy would revive within a reasonable period of time and search for sound businesses that had survived the shakeout. The economy has certainly come back. Gross domestic product in the third quarter rose at a stunning 7.2 percent annual rate, the government announced Thursday.

It is a lot harder to determine where we go from here.

Byron Wien of Morgan Stanley, one of my favorite strategists, points out in his Oct. 22 letter to clients that a review of stock market sectors for the year so far finds "the best performance has come from information technology," up 39 percent. He worries that many of these rising stocks aren't of particularly high quality, and that they have come too far too fast. So he has dropped technology (and financials) into the "unfavored" category.

He notes that tech stocks currently have a price to sales (P/S) ratio of 2.9 compared with a historical average of 2.0 and a price to earnings (P/E) ratio, based on expected profits for the year ahead, of 29 compared with a historical average of 20. Both P/S and P/E, then, exceed their own norms by nearly 50 percent.

The authors of the Business 2.0 article, Michael V. Copeland and Paul Sloan, make the same point, but with more affection for hyperbole.

"Crazy valuations are back," they write. They scoff at Yahoo (YHOO), the prime online portal, which carries a P/E of 119 (based on estimated 2003 earnings), and Amazon.com (AMZN), at a forward P/E of 96. "Such valuations are beyond optimistic; they're hallucinatory."

The authors also fret that day traders and margin buyers are back -- and so is "momentum trading," that is, the practice of buying stocks because they are going up. "The ranks of top-performing stocks teem with small tech companies that have risen many times over for no apparent reason." A prime example, according to Copeland and Sloan: Ask Jeeves (ASKJ), maker of sophisticated Internet search technology, which has soared 789 percent since the beginning of the year.

While it's true that margin-buying (that is, purchasing stocks by borrowing) has exploded, Copeland and Sloan -- as well as many other tech naysayers -- are getting carried away with fears that history will repeat.

But this is not the late 1990s, when many valuations truly were hallucinatory. For instance, adjusted for a reverse split, Priceline.com (PCLN), the online travel discounter, traded at a high of $990 a share in 1999, a time when it was hemorrhaging cash; that's a P/E of infinity. Today, it's $29.98, and expected earnings for 2003 (the first profitable year in the company's history) are 50 cents a share, for a P/E of 60.

Consider eBay. In March 2000, it was trading just where it is today, a little less than $60 a share. The difference is that in 2000, eBay earned $48 million; this year, it will earn about $400 million.

Also, remember that while the Nasdaq composite index has risen nearly by half since I wrote my March column, it's still more than 60 percent below the peak it reached three years ago, even though U.S. economic output has grown by more than $1 trillion. Sure, stock prices could drop in the coming months. You never know what will happen in the short term. But to equate 2003 with 1999 is dead wrong.

Still, while P/E ratios aren't in the late-'90s stratosphere, aren't they high? Consider Ask Jeeves. According to a Yahoo Finance survey of the analysts who follow the stock, it's projected to earn 53 cents in 2004, a jump of nearly 50 percent. Let's say that earnings growth slows by half, to 25 percent, for the four subsequent years. That means that, by 2008, the company will be earning $1.29 a share. A price of $20 today doesn't seem like a lot to pay for such sparkling earnings.

Of course, there is no guarantee that Ask Jeeves will be so profitable in five years, but the prospect of such earnings is certainly reasonable. And it is that prospect -- not simply insane "momentum" buying -- that has pushed up the stock. At the start of the year, Ask Jeeves traded at $2.24 a share. Which price is more hallucinatory for a booming company that will earn 53 cents next year? Two bucks (a P/E of 4) or 20 bucks (a P/E of 38)?

Under the textbook definition, the value of a company is determined by the flow of cash it will generate in the future -- not in the present or the past. If a company today is making paltry profit, or none at all, it can still be valued, appropriately, at a relatively high price -- as long as there are sensible expectations of strong profits in the future.

Investors who bought eBay in mid-1999 paid $20 a share (adjusted for splits) for a company that was earning only 2 cents year, for a P/E of 1,000. Were such investors stupid? It doesn't seem that way, with earnings having risen to 70 cents and eBay having roughly tripled in price.

Not every tech stock is eBay, but long-term investors who chose wisely have done extremely well with many technologies, even though shares are down significantly from their bubbly highs. An investment of $10,000 in Intel at its initial public offering in 1986 is worth $1,105,000 today. An investment of $10,000 in Dell at its June 1998 IPO is worth $3,670,000 today. A few winners like that make up for a lot of losers.

Having losers is almost certain if you own tech stocks, which are naturally volatile in an industry that's young and vulnerable to competitive and economic shocks. The best strategy is to soften the inevitable blows through, first, broad diversification and, second, the purchase of shares that aren't outlandishly priced.

The Oct. 27 issue of Dow Theory Forecasts offers one approach: buy techs that are not too big and not too small. In an analysis of 1,900 tech stocks, the newsletter found that the median P/E ratio, based on 2003 earnings, for small-caps (those with market values of less than $1 billion) was 40, and for large-caps (values over $8 billion), the median P/E was 34. For mid-caps, however, the median P/E was a more reasonable 27. For some reason, mid-caps are in less demand.

You shouldn't be dogmatic and buy only mid-caps, but the mid-cap tech arena seems to be a particularly happy hunting ground. In this group, Dow Theory's top pick is SunGard Data Systems (SDS), which serves the financial industry; it is expected to increase its earnings at a rate of 18 percent annually over the next five years and trades at a current P/E of 23.

Even Business 2.0 includes a mid-cap tech stock in a list of 10 "stocks to buy." It's Take-Two Interactive Software (TTWO), maker of popular Grand Theft Auto games. It carries a PEG (P/E divided by growth rate) ratio of just 1.1, an indication that it could be a bargain.

And bargain is the word right now. In March, when practically everything was cheap, it was easier to purchase stocks such as Netflix and Yahoo. Today, it's time to be more selective. Look, for example, at what the value-seekers are buying.

For example, Sanford Bernstein & Co., the New York research and money-management firm, includes among its top holdings Hewlett-Packard (HPQ), which closed Friday at $22.31 and, according to a consensus of analysts, should earn $1.41 in 2004; and Vodafone Group (VOD), the mobile communications firm, at a P/E (based on 2003 earnings) of just 16.

The Al Frank Fund (VALUX), which is up 46 percent this year (but carries an absurd expense ratio of 2.3 percent), owns, among its top holdings, ValueClick (VCLK), tech-based marketing; Diodes (DIOD), semiconductors, at a P/E of 24; and Nam Tai Electronics (NTE), a mid-cap Hong Kong-based electronics manufacturer, at a P/E of 40 and a growth rate of around 30 percent.

In addition to its selection of EarthLink, Value Line, also known for its circumspection, includes Cognizant Technology Solutions (CTSH), which offers customized information technology systems for large corporations, in its 20-stock model portfolio for near-term growth.

Another fruitful area for finding well-priced tech stocks is abroad. Tiny Matthews Asian Technology Fund (MATFX) has been one of the year's best performers, up 51 percent. Its top holdings include SK Telecom (SKM), the thriving Korean wireless company at a P/E, based on expected 2003 earnings, of just 10, and a slew of Japanese techs, such as game-maker Nintendo (NTDOY), at a P/E of 12.

Another intriguing Asian choice is Shanghai-based Sina Inc. (SINA), a global online media company aimed at Chinese users. Sina shares have quintupled this year, and, at a P/E of 67 based on this year's earnings, it's hardly cheap in conventional terms, but it's growing at a phenomenal pace in a market that's probably the best tech audience in the world. Among European tech stocks, SAP (SAP) is a giant in business software. This stock, too, appears expensive at a P/E of 35, but the franchise is solid, and its prospects are bright as the economy recovers worldwide.

As for mutual funds: Pickings remain slim. Dreyfus Premier Technology Growth is still the top choice, with average risk, only a tiny amount of cash, relatively low turnover and, in Mark Herskovitz, a manager who has been at the helm for six years, since its inception. The fund has returned an annual average of 9 percent for the past five years. It's far from perfect -- with a load of 5.75 percent and annual expenses running 1.6 percent -- but, from what I can tell, it may be the best of a mediocre bunch.

Finally, take a close look at a more general fund I have mentioned many times over the past decade: Legg Mason Value Trust (LMVTX), whose manager, William Miller, has beaten the benchmark S&P 500-stock index for the past 12 years. This isn't a tech fund, but Miller's top holding is Amazon, which represents 9 percent of his portfolio, followed by wireless provider Nextel Communications (NXTL) at 7 percent. That's a sign that owning tech stocks, even in November 2003, doesn't necessarily make you a fruitcake.

Among the stocks mentioned in this article, James K. Glassman owns Dell and Amazon.

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