Tech Gets Tough Love
By Fred W. Frailey
Before technology stocks can grow up, says this expert, they must learn better behavior.
Consider Fred Hickey's awkward position this past half decade. In the technology sphere, he's the insider's insider, the guy hedge-fund managers and tech analysts (not to mention newspaper reporters) go to when they want to cut through clutter and know what's going on. His monthly newsletter, High-Tech Strategist, points investors toward the best buys. So he must have made a killing.
Well, no. Hickey didn't plan it this way, but High-Tech Strategist ($95 per year; Box 3133, Nashua, NH 03061) became the rallying point for those, including himself, who thought that technology stocks were priced far beyond the zone of rationality. "I'm writing stuff," he says, "that is, you know, tough love." His December 1998 issue was headlined "How Big Can a Bubble Get?" It turned out the bubble could become almost twice as big, because the Nasdaq Composite index proceeded to rise 86% in 1999.
Today Hickey has a right to feel vindicated. He may have missed a lot of gains on the way up, but he's now missing all the losses on the way down, while awaiting his moment to be a buyer again. When will that moment arrive, and what industry leaders are attractive at the right price? We journeyed to Hickey's modest house on the outskirts of Nashua and began a most unusual living-room conversation.
KIPLINGER'S: For a tech investor, haven't you stood on the sidelines for a long time?
HICKEY: Beginning in 1995, I became progressively more cautious. By 1999 I wasn't buying the stocks at all. Being a technology guy who cares about value, I couldn't buy at those levels. It was against everything I believe in.
Still and all, are tech stocks the place to be in the long run?
Oh, yes. All the arguments that the bulls use to justify buying these stocks are valid. It's just that they didn't consider valuation. Technology is the highest-growth area of our economy. It is the place where stocks go up the most. It is the area in which the U.S. has the most expertise. There's always innovation, and that means there is always opportunity. Only in this period of insanity were my hands tied.
Can someone be a buy-and-hold investor in technology?
That's difficult, if you mean in the same way you could have bought Procter & Gamble (PG) or Gillette (G) and put the shares in a drawer for 20 years. With technology you have to factor in obsolescence. The hottest companies in the late '70s and early '80s were Prime Computer, Wang Labs, Digital Equipment, Data General. None is around anymore.
But Cisco Systems (CSCO) was an industry leader five years ago. So were Microsoft (MSFT) and Intel (INTC). Is five years a better buy-and-hold period?
The question is whether these companies will continue to grow -- whether they are good investments today. Microsoft's revenue growth is almost zero.
How much longer will this technology sell-off torture people?
I only know that now is not the right time to jump in. The Nasdaq's price-earnings ratio is still 100. That is nowhere near the bottom of a market.
People poured money into technology funds after the tremendous run-up in 1999, and most of the money came at the end of the advance. People still have faith. Only recently have we seen some redemptions. People will react later -- it just takes a while. Siebel Systems (SEBL) , Brocade Communications (BRCD) , PMC-Sierra (PMCS) , Broadcom (BRCM) , Sycamore Networks (SCMR) , Ciena (CIEN) , Veritas Software (VRTS) , Check Point Software (CKP) and EMC (EMC) are all selling at more than 100 times earnings. There's still a big shooting gallery.
The Federal Reserve Board has already cut short-term interest rates once this year. Can rate cuts revive tech stocks?
Not for long. The Fed is pushing on a string. The troubles in the PC, cell-phone, telecom and Internet-infrastructure markets have very little to do with interest rates and everything to do with sated demand, market saturation, oversupply and overcapacity. An interest-rate cut addresses none of these problems.
You use some inflammatory words in your newsletter -- "lunatics" and "maniacs" -- to describe the leading tech investors. You've mentioned the Janus funds in this vein. On the other hand, we've always thought they were pretty bright people.
In any market mania, the common wisdom is that whatever the leaders are doing is correct. But at the same time, go back a year or so and look at what other people were saying -- economists Paul Samuelson and Henry Kaufman, Vanguard's John Bogle, Sir John Templeton, Warren Buffett and even Microsoft's Steve Ballmer and Bill Gates. All warned of crazy valuations.
Look, I'm not waving a victory flag. We're still early in the tech correction. When history is finally written, we will see who was correct. Was it the Samuelsons and Bogles and Templetons, or the people running the momentum funds?
For the larger, established tech stocks, the carnage didn't begin until last September, when evidence accumulated that business wasn't so hot. Doesn't this suggest that valuations don't matter until business begins to deteriorate?
Understand, there's no precedent for this -- none whatever in the history of the stock market. In 1929 Radio Corp. of America was the Internet stock of its era, with unlimited possibilities. Its highest P/E was 80, not the multihundreds. Are these levels sustainable? There are certain historical levels they always go back to.
You may not know when the slide will end, but do you have any feel for where it will end -- at what level?
Look at the Nasdaq Composite. Its P/E is about 100. What would be typical?
How about 30?
That would take you below 1000 on the Nasdaq, versus about 2400 now. You could see the Dow Jones industrial average in the 5000 range.
So how would you evaluate a classic tech stock like Cisco Systems? What valuation does it deserve?
There are a lot of variables, but a generalized standard that has held pretty well historically is that the P/E should match the growth rate. So if your earnings are rising 30% a year, your P/E is 30. With Cisco, what's the real, underlying growth of the business? Cisco went on a massive spree buying companies, taking their sales, and writing off the excessive purchase prices.
What's wrong with buying potentially profitable companies?
Nothing, and Cisco did a great job targeting the technologies that it didn't have expertise in. That's fine. What's not fine is paying $6 billion for a tiny company and writing off all the costs. You might say Cisco purchased its R&D off the shelf and said there was no ongoing cost for this. To me, it says that reported earnings are higher than they perhaps should be. Meanwhile, Juniper Networks (JNPR) has come out of the blue and taken 30% of the router market away from Cisco.
So can Cisco grow at a real rate of 30%, versus the 50%-to-60% rate it has shown recently?
Yes, but even 30% isn't sustainable, particularly in the downturn we're having. Look at the vendor financing going on. Where do you think Cisco and Lucent Technologies (LU) and Nortel Networks (NT) find customers, qualified or not? They lend them the money! And then these companies send the money back and it's recorded as sales. Just recently Cisco took a $275-million write-off because of bad investments in these companies. Is it true demand if you do this?
I've argued that there is tremendous oversupply of networking infrastructure. This is certainly true of voice and data in telecommunications. That's why pricing by the service providers -- WorldCom (WCOM) , AT&T (T), Sprint (FON) -- has collapsed. They're killing each other in a price war for voice business. Similar price cuts have come in data networking. Nobody is making money. If you have an oversupply, you won't have 30% growth in the underlying infrastructure. It may become zero. Cisco is not a buy now.
What about Lucent and another beaten-down stock, Motorola (MOT)? Lucent was thought to be like Cisco -- completely invincible. But it wasn't. It stumbled, and the price collapsed, the same as Motorola. But if you are an established presence in networking, as Lucent is, or the wireless business, as Motorola is, you have sales, and sales can be valued. A good corporate manager should be able to make some money. Lucent trades for two times sales, and Motorola for one times sales. Motorola lost market share in cell phones, but does that mean it can't be turned around? No. I would buy Motorola before I would buy Cisco.
Are there signs of a bottom in technology stocks that investors should look for?
Yes, when people have dumped them and dumped them and really given up on the whole sector. It helps also to have a trend that points toward a pickup in business. In the early 1990s Windows 3.1 caused a big upgrade cycle in PCs when sales had been depressed.
There are also general market indicators. You don't want surveys of money managers to show almost the highest bullish level in history. People are still convinced there's not a problem. You want to see higher cash levels in mutual funds. Right now the level is 6%, up from 4%. But we peaked at 13% during the downturn in 1990. And you don't want to see CNBC's ratings increase, as they did into last summer. My name for CNBC is Tout TV, or Bubblevision.
And finally we have to see momentum investing discredited. There's no track record of its success, except during short bursts of manic markets.
,b>How can someone spot the next Cisco or Microsoft?
When a company has good technology, it becomes known in the venture-capital community and in particular among the gearheads -- the engineers, software guys, propeller heads. You tap into that knowledge by reading trade magazines.
What are some great companies out there that are fairly small and that could be giants down the road, regardless of price?
They all sport multihundred P/Es, so this is a hypothetical question. I like Siebel Systems, which is involved in what is known as customer-relationship management. In other words, Siebel automates your sales force. E.piphany (EPNY) is a competitor and doesn't make money, but it has good products. BEA Systems (BEAS) does middleware, which is Web-server software that's invisible to the end user. And there's EMC in data storage.
Now, can I buy any of these companies? No. That's frustrating. It's easy to find the best companies but much harder to find a price you can buy them at, so you won't be killed by all the risks that are there -- the risk of the economy turning down, the risk of obsolescence, the risk of stock prices falling because they're just too high.
It's commonly thought that value investing -- that is, buying stocks at low valuations and selling them at higher valuations -- doesn't work in technology. But that's exactly what you do.
And I've been successful at this for 20 years. I even survived this period. There's nothing wrong with getting a 6% rate of return while you're waiting for better values. The biggest percentage gains come out of a recession or a huge bear market. After the crash of 1987, I made huge amounts of money, and I cleaned up again in 1991.
You can see through my writing how frustrating it was to have this mania go on and on because it took me out of the game. Right now, I don't look too smart.
The last word
I don't look too smart. These days, the 44-year-old Hickey ought to be saying, "I told you so, you dummies," but he lacks the necessary arrogance. Nor will he agree to go on CNBC to discuss the tech-stock bonfire because he holds the network partly responsible for the mania that led up to it. "One of the things I measure," he says, "is how popular I am or how many calls I'm getting from people I've never heard of before. Maybe that's not an indicator of a market bottom, but it's one I consider."
Reporter: Courtney |
