Tech
rebound won’t be quick
It seems
that the bad news just doesn’t stop when it comes to the technology sector
these days. This is in sharp contrast to where we were a year ago, with the
NASDAQ 100 trading at nearly 4,600 – more than 112 per cent higher than the
March 29, 2001 closing price. While tech stocks rose to their glory on momentum
and optimism, today’s tech stock investments are being severely punished for
the lack of momentum in revenues and profits. It’s time to revisit the question
that I’ve been hearing so much of during the past several months – “should I
sell my tech holdings, buy more, or just hang on to what I’ve got?”
Recall that
future returns from stocks are largely driven by the following factors:
Ÿ
industry
fundamentals;
Ÿ
interest
rates; and
Ÿ
current
stock prices (and other company fundamentals).
Read the
newspaper on any given day and you’re likely to see that the technology
industry remains fragile. Fat inventories and continued slowing in tech
spending means that the current surplus of tech equipment will take awhile to
work its way through the economy. Then, as inventories slim down, demand must
persist in order for growth in revenues and profits (if any) to regain
strength.
As we’ve
discussed previously, it’s unlikely that interest rates will rise. So far this
year, US interest rates have fallen substantially. While that’s not a guarantee
of good returns, it is a positive sign for the future of stock prices.
Morningstar.com
shows a beefy price-earnings (P/E) ratio of more than 47 times, but it’s
important to look a little deeper into that figure. Most published P/E
calculations exclude companies with negative ratios (and that’s the case
elsewhere within morningstar.com). Nearly 30 per cent of the NASDAQ 100’s top
twenty-five stocks have negative P/E figures because their earnings are
negative. When Montana-based investment researcher and money manager InvesTech
examined all 4,800 stocks trading on the NASDAQ, they found that the true
composite P/E ratio was 94 as recent as two weeks ago. In fact, InvesTech found
that the NASDAQ’s 4,800 stocks, at their peak, had a P/E ratio of about 245
times.
Those are
frightening figures when compared against the financial performance that the
constituent companies must deliver in order to provide shareholders with a
decent return. To provide a 10 per cent annualized return over a ten-year
period, NASDAQ’s 4,800 companies would need to growth their profits by more
than 23 per cent annually over ten years – an enormous figure, particularly
when put in the context of today’s economy. Even if we take the P/E ratio of
47, profit growth must still exceed 15 per cent annually to give investors an
annualized return of 10 per cent over a ten-year period. It can be argued that
some of the companies in the NASDAQ could generate that type of internal
growth, but it’s quite a tall feat for 4,800 of them to do so. Though current
valuations are quite important, let’s not get hung up on P/E ratios. Other
market activities point to desperation for some big players.
Lucent
Technologies spun off its optic components subsidiary, Agere Systems Inc., in
the midst of horrible conditions this week. The only sensible reason for going
ahead with the planned initial public offering (IPO) is that they needed the
money badly to reduce their huge debt load. This is just speculation but
consider the following facts.
Prior to
actual trading, the price of the Agere IPO was cut three times from the US$15
to US$20 range down to US$6. The end result:
Lucent received just US$3.6 billion in proceeds – just over half of
their initial expectations. It’s no secret that the market’s infatuation with
tech stocks (including fibre optic stocks) is a faint memory. Also, Nortel Networks
has been planning a very similar spin off but has continued to delay it since
they felt they wouldn’t get the subsidiaries true value from such a bad market
environment. Even non-technology companies, such as mutual fund firm Altamira,
have delayed planned IPOs due to the general market unrest. However, Nortel
isn’t the only tech firm delaying an IPO.
Looking to
the venture capital level of the market, IPO activity in the tech industry hit
a brick wall. Venture capital backed IPOs are essentially small private
companies that are preparing to trade in the public markets for the first time.
In a survey of US venture capital funds, technology IPOs dropped 83 per cent
during the final quarter of 2000, compared to the same period in 1999 (source: PricewaterhouseCoopers MoneyTree Survey in
partnership with VentureOne), capping the third consecutive quarter of
declining IPO activity.
If Lucent
thought the market would turn around relatively soon, it’s reasonable to
conclude that they would have delayed their IPO until more a favourable
sentiment had returned to the market. The odd timing of the Agere IPO may be
indicative of Lucent’s own sentiment at the moment.
My December
22, 2000 article was the last time I gave an opinion on tech stocks. In a nutshell,
I said that significant risk remained in the group and that buyers (that is if
you’re buying at all) should be cautious by avoiding lump sum purchases. I’d
say my sentiment hasn’t really changed since stocks remain quite expensive in a
market environment that remains unfavourable. That said, here are a couple of
suggestions for those currently holding tech investments.
If you’re
holding tech mutual funds or stocks, sitting tight might be your best bet.
While more downside risk remains in the short-term, there is less risk now than
there was a few months ago. You may want to contemplate selling if technology
still comprises a disproportionate amount of your total portfolio. For balanced
portfolios (a mix of stocks and bonds), technology should account for a maximum
of 10 to 15 per cent of your total portfolio. For aggressive investors, that
maximum could be raised to 20 or 25 per cent at most. Finally, always make sure
to look beyond your tech-specific funds. Many “diversified” foreign and domestic
stock funds hold some technology, particularly if using a growth-oriented
investment style. That can help you gauge your portfolio’s total technology
exposure and take the course action that’s right for you.
Dan Hallett, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
by e-mail at dhallett@sterlingmutuals.com. Sterling Mutuals Inc. is registered
as a mutual fund dealer in Ontario, British Columbia and Manitoba.