When I sat down to write "Trains, Planes & Dot Coms" on January 2nd of this year, I felt the stock market was approaching a peak. With twenty years in the business, I had never witnessed stock market gains of that magnitude. The Nasdaq had risen over 85 percent in 1999—a benchmark no other index had accomplished in the entire century. Stock prices moved as much as 700% in a single day for an IPO, or up as much as 50% on a favorable recommendation by an analyst. The market was no longer driven by fundamentals or facts. It moved on hype and hyperbole. Even more alarming to me was the fact that the majority of gains were concentrated among companies that were losing money.
Media pundits and Wall Street analysts were only too happy to spin the mania in terms of "New Era " theorems. Profits were no longer relevant—just look at sales growth. If sales growth was nonexistent, you had to look at hits, eyeballs or stickiness. There was an analyst or a theory capable of explaining every absurdity. Wall Street was rolling out the hype, investors were being pumped, and stock prices kept rising. Television commercials promised investors great wealth through day trading. Financial journalists heralded the times as the era of financial democracy. Individual investors were kings-in-the-making as they took control of the financial markets from institutions that had long dominated the money game.
As a money manager I was forced to invest in some of these stocks. I gritted my teeth with reluctant resolve and moved into the technology sector. Why? Because it was the only game in town. Other growth sectors like drugs, financial, and consumer companies were faltering. The only pond with fish was technology. I invested my clients' money in the Four Horsemen of the Internet* AOL, Amazon, Yahoo and CMGI. We were making money in these stocks for no apparent fundamental reason. When we bought AOL, our holdings doubled in a single month when it was added to the S&P 500. CMGI would move up 25% in a single day on either an analyst recommendation or an announcement of a pending deal. The Price/Earnings multiples on these companies was astronomical, yet they kept heading higher.
With the end of the year approaching and the advent of Y2K upon us, we bailed out of these companies in our non-taxable accounts and held on to AOL until the following year for our taxable accounts. We began 2000 heavily in cash and began to invest our money defensively in food, defense, drugs, natural gas, and a strong position in utilities. I felt a stock market downturn was eminent. You can imagine my concern when instead of going down, the Nasdaq continued to rise until it peaked at 5132.52 on March 10th of this year.
We made another foray into techs in May 2000 after a substantial downturn had occurred. We began to trade out of these stocks again in July. This time we were unable to get out of all of our positions fast enough before another round of selling began in technology. We have now sold our remaining positions in technology to offset capital gains.
We began to liquidate our remaining holdings in technology in the third quarter because I sensed that all was not well with the stock market and the economy. During this summer I experienced an epiphany that led me to begin writing my Storm Series. The economic numbers and annual reports I was reading painted a completely different picture than the one portrayed in the papers or on the financial networks. I became convinced that a potential series of storms or in fact "The Perfect Financial Storm" was headed toward our shores. As I began to write the Storm Series, I noted that I held the minority opinion. One would have to visit Internet bear dens to read an opposing view to the forecast of sunny skies coming from Wall Street. When I began the "Storm Series," I had gone out on a limb—but the numbers I was starting to see were too compelling to ignore.
This brings me to our present juncture. When I wrote "Trains, Planes & Dot Coms" on 2 January 2000, I was a bit early. The Nasdaq went on to advance more than 20% before the final downturn began in March. Now as I enjoy my morning coffee and turn on the financial news, I see network anchors and Wall Street moneymen extolling the virtues of technology again. Chief among their pitch is that many of these stocks have seen their share prices plunge.
Numbers Don't Lie
As these graphs indicate, Microsoft, Cisco, and AOL have suffered dramatic pullbacks. Mid-December, the Nasdaq is down 43% year-to-date and down nearly 55% from its March 10th peak. The day this newsletter was written, the Nasdaq was down over 7%. Absent from the spinmeister's discussion is the fact that the Nasdaq is still selling at 105 times earnings. Even though Cisco's shares are down, they are still selling at a P/E multiple of 80—hardly a bargain.
The "B" Word
Another topic absent from financial network babble is the word "Bear" Market. If dropping 55% from its peak is not a bear market than will some one please explain what is? The Nasdaq has traditionally sold at multiples of 20 or more, which is characteristic of most growth stocks. If the Nasdaq were to trade at fair value, the index needs to fall to the 500-1000 range. If that doesn't happen, then growth rates for the Nasdaq would need to rise at a much faster pace. Judging by all of the earnings pre-announcements, this seems unlikely.
My concern for the technology sector does not rise from the assumption that innovations will stop. Most assuredly, they will continue. My hunch is earnings multiples will continue to contract as rationality returns to the markets. The problem for individual investors will be uncertainty about the market. Unfortunately, that uncertainty will be more apparent if invested in the tech sector. Warren Buffett's mentor, Benjamin Graham, wrote in The Intelligent Investor: A Book of Practical Counsel, "The more dependent the valuation becomes on anticipation of the future—and the less it is tied to a figure demonstrated by past performance—the more vulnerable it becomes to possible miscalculation and serious error."
Profit Found in NOT Having to Reinvent the Wheel
The lesson that Buffett learned from Ben Graham is that the intrinsic value of a company is more difficult to measure when earnings and cash flow are unpredictable. So an investor runs the risk of over-paying for a company when the very nature of its business is in a state of constant flux. The reason Buffet stays with companies like Coca-Cola and Dairy Queen is that their earnings are more predictable. It's hard to imagine that much will change at Coke, See's Candy or Dairy Queen over the next two decades. The Coke formula, which has remained the same over the last century, will likely hold its constancy in this new century. The same will hold true for See's Candy and Dairy Queen. All three businesses will generate large amounts of cash that will allow those businesses to grow well into the future. Additionally, Coke or Dairy Queen will not have to invest huge sums of money in R&D to remain competitive.
Ravages of R&D Expense
To illustrate this point, one only needs to look at the Technology Trifecta of the '60s and '70s: IBM, Xerox and Polaroid. IBM has had to struggle to maintain its technology lead throughout the 80's and 90's. Its stock price has done well these last few years thanks to share buybacks and financial engineering. Internally IBM's sales growth and profits have been minimal.
Another tech stalwart of the last tech mania of the '70s is Xerox. The shares of Xerox hit a peak of 1.87 a share in August of 1972. Even though the shares split six-to-one since 1972, Xerox stock is now trading around a share. Its bonds have been relegated to junk bond status. The company now stands on the verge of bankruptcy if it cannot pare down its debt through asset sales.
Many may not realize it, but Xerox was instrumental in inventing the personal computer, the windows operating environment, and the mouse.
The problem for all technology companies is that they have to contend with a constantly changing technology environment. This competition produces too many difficult "what-ifs" to determine the variables that will impact sales, earnings and ultimately a company's stock price. The dustbins of history are full of failed but once-bright technology stars. These trendsetters have either disappeared or been swallowed up by industry giants.
Given the uncertainty that is presented in technology investing, and the high earnings multiples that these companies command, investors have to be extremely careful as to the prices they pay for growth in earnings. This is especially true when those growth rates are subject to so many vicissitudes. Peter Lynch, the great growth investor, always tried to invest in growth companies when their P/E ratios were less than their earnings growth. Even though Lynch favored growth companies, he very seldom overpaid for them.
A word of caution for today's investor—there are many growth companies with great growth potential. Unfortunately, very few of them are attractively priced, even with the current correction. The Nasdaq and the tech leaders that make up the index have seen their market caps shrink, and yet they are still extremely overvalued.
Samson's Pushing on The Support Pillar
The growing problem for the technology sector is lack of access to an abundant supply of cheap capital. The era of easy money has ended as the financial environment has changed. Credit spreads have widened, banks have tightened their lending standards and the Nasdaq's fall has reduced the capital available for new tech IPOs. The change in the financial environment has removed a major support pillar that has buoyed the capital-spending boom of the past few years. This is why you see a parade of sinking companies announcing lackluster earnings and sales shortfalls. In my estimation, the technology sector will not be immune to the economic slowdown that is ahead of us. The industry can't continue to boom if the rest of the economy is slowing.
Buyers Beware of A Bear Market Rally
There may indeed be a Bear Market rally around the corner. Rumors are flying that Greenspan may lower interest rates in January. Our new President and Congress may pass tax cuts that may curtail an eminent recession and help bolster the market. But these actions will only prolong the inevitable. The financial imbalances and the credit excesses of the last eight years will have to be faced. The day of reckoning is at hand. The storm fronts I have written about in the Storm Series are already buffeting the American economy. We have seen junk bond defaults, bankruptcies, widening credit spreads, declining stock prices and now, an economy that appears to be setting its brakes. What remains to be seen is how policymakers deal with these storm fronts. Their wisdom will determine whether we eventually experience a recession or a depression.
Highly Recommended
* The Four Horsemen of the Internet is attributed to James Dines, Editor of The Dines Letter
