George Cole, here is part of yesterday's write up
in WSJ:
January 18, 2000
interactive.wsj.com
Market on a High Wire
Market's Value Continues Ascent,
But Just How High Can It Climb?
By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
THE MOST-EXCITING business to come along in a
century had sales of $30 billion last year, a bit less than
Kmart's. But it lost billions, and will lose at least twice
as much this year. For this, the price tag is a cool $1
trillion -- more than the gross domestic product of
Canada.
That, in essence, is what investors
in the Internet sector have bought: an
incomparable business opportunity
at an inexplicable price.
Euphoric valuations are hardly the
preserve of the Internet. Fifteen
technology stocks are today worth
more than the entire market a decade
ago.
All stocks are together worth a
record 172% of U.S. economic
output, more than double the level before the 1987 plunge.
Does this make sense?
Even giddy investors enriched by the surge in stocks now
wonder how high is up -- and, if the market teeters, how
low could be down. "Doesn't this market scare you at
all?" asked one participant on an Internet message board
recently. Last week, Federal Reserve Chairman Alan
Greenspan pondered whether this period would be
remembered as "just one of the many euphoric speculative
bubbles that have dotted human history."
It is impossible to say conclusively whether the market is
overvalued, much less predict when it might tumble even
if it is overvalued. Stock prices long ago broke all
historic valuation records compared to earnings,
dividends or any other traditional benchmark. They have
kept rising long after skeptics first labeled the market a
bubble -- not surprising, perhaps, given the durability of
strong economic growth, low inflation and technological
advance that has fueled them.
But alarm bells have been set
off anew by the Nasdaq
Composite Index's 60%
moonshot in the past five
months. It has recovered from a
new year sell-off, closing near
a record at 4064.27 Friday,
five times as high as its year-end 1994 level. The Dow
Jones Industrial Average finished at a record 11722.98
Friday, triple its year-end 1994 value. (Markets were
closed Monday for the Martin Luther King holiday.) Most
telling is that in many cases, Wall Street no longer even
bothers trying to defend the valuations of Internet and
technology stocks.
Erik Voss, a fund manager for Conseco Capital
Management, describes being told by a Wall Street
analyst covering Internet infrastructure companies, " 'The
opportunity is so huge there, you just have to own these
things.' I said, 'Can we talk about valuation at all?' And
his response was, 'If you have to ask about valuation, you
can't afford it.' "
Concludes Mr. Voss, "A lot of investing, at least the
technology investing, has turned from fundamental
analysis into mainly game theory: you make money by
being able to sell to somebody at a higher price, and that's
all."
Actually, outside technology and the Internet, valuations
are far more terrestrial. Indeed, the average stock is
barely higher today than two years ago. When it comes to
technology, even the most bearish analysts agree the
microchip and Internet are changing almost everything in
the economy.
BUILDING A THRIVING company off that trend is
another matter. In the past year, three online-travel
services, five online-job recruiters, six online-music
distributors, seven business-to-business e-commerce
companies and 17 health-related Web sites have gone
public and many have price tags of hundreds of millions,
even billions of dollars. Yet they are fighting for a slice
of a still-tiny market against more-experienced and often
larger traditional companies also muscling onto the
Internet, not to mention tens of thousands of private
Internet companies, many financed by huge dollops of
venture capital.
To give one example: Five online job-search companies
are together priced at $1.2 billion, yet online-job
advertising this year is projected at only $525 million,
and already there is fierce competition for that money --
from traditional companies that own the two largest job
sites and from some hundreds of other sites.
Similarly heroic assumptions underlie the valuations of
some traditional companies. Wal-Mart Stores has grown
rapidly this decade to become the world's largest retailer,
but with a price/earnings ratio 2.5 times as large as that of
other retailers, profit would have to match analysts'
bullish estimates of 14% annual growth for seven more
years to "grow into" its valuation (with no change in its
stock price). To achieve the nearly $400 billion in sales
such growth implies, Wal-Mart practically would have to
put every other general merchandiser out of business. Intel
dominates sales of personal-computer microprocessors,
but its $344 billion market value is double world-wide
annual sales of PCs. Thanks to the high prices of such
colossal companies, the Standard & Poor's 500-stock
index stood at 31 times trailing earnings at the end of
1999, double its 40-year average.
Some bulls don't even try to rationalize today's valuations,
arguing the world has made such measures obsolete.
"It's a new world order," says Robert Froehlich, vice
chairman and chief investment strategist at Kemper Funds.
He says investors should own Cisco Systems, Motorola
and Intel at any price and not worry about the valuation.
"We see people discard all the right companies with the
right people with the right vision because their stock price
is too high -- that's the worst mistake an investor can
make. The people who have missed the bull market are
the people who are on the sidelines trying to figure out
how to value these things as opposed to getting into the
market."
Those with long memories
remember similar talk in 1972 about
the so-called Nifty Fifty
"one-decision" stocks -- essential
investments at any price. They collapsed in the 1973-74
bear market. Talk of new eras has prevailed at the height
of most speculative booms, whether the 1920s in the U.S.
or the 1980s in Japan. When bear markets hit, notes Fred
Hickey, editor of the High Tech Strategist newsletter, tech
stocks are hit hardest. From 1929 to 1932, Radio Corp. of
America (RCA) fell 98%; from 1969 to 1970, 10 leading
computer stocks including International Business
Machines and Sperry Rand fell 80% on average. At their
1974 lows, Honeywell had fallen 90% from its peak,
NCR 85%, and Control Data 95%. Even in the
much-milder 1990 bear market, Mr. Hickey notes, in the
space of 12 weeks Intel fell 46%, Compaq Computer
48% and Oracle 76%.
What is the value of a stock, anyway? The answer always
has been part art, part science, so it is impossible to say
conclusively whether today's prices make sense. Analysts
agree on three paramount factors: profit growth, interest
rates (or inflation) and risk. Depending on your
assumptions for these three factors, you can come up with
almost any value for stocks.
THAT SAID, examining these factors reveals a
fundamental underpinning for stocks' rise. Profits have
grown steadily since 1992 with just a brief interruption
during the 1998 emerging-markets crisis, and companies
such as Microsoft and General Electric are growing at
rates never seen for companies of their size. Interest rates,
although they have risen in the past seven months, are
their lowest in a generation, which increases the present
value of future profits. With the bull market and, soon, the
economic expansion both the longest in a century,
investors have come to see stocks as a less-risky
investment. These factors help explain why all stocks are
highly valued, and fast-growing stocks such as in
technology even more so.
"Market-valuation levels have doubled from their historic
levels, because investors feel extremely confident about
the future," says Ed Keon, director of quantitative
research at Prudential Securities. "Therefore those stocks
that have the greatest exposure to the future have benefited
enormously and disproportionately." The S&P 500's 31
price/earnings ratio is misleading. The 10 largest
technology stocks plus Yahoo!, together making up a fifth
of the index, had a combined P/E of 74. Without them, the
market's P/E drops to 26, according to Salomon Smith
Barney. Half the companies in the index trade at 20 times
earnings or less.
Worth the Wait?
How long it is likely to take for certain big-name company stocks to grow into their
price-to-earnings ratio-a; Technology stocks appear in bold.
Company
P/E
ratio
5-year profit
growth rate
(forecast)
Years for
profit to
double-b
Years
to
'grow
into'
P/E-a
Yahoo!
735
50%
1.7
7.8
America
Online
186
50
1.7
4.4
Cisco Systems
184
30
2.6
6.8
Sun Micro
110
20
3.8
7.0
Coca Cola
49
15
5.0
3.3
General Electric
49
15
5.0
3.2
Exxon Mobil
39
7
10.2
3.4
Johnson &
Johnson
37
13
5.7
1.5
SBC Communic.
22
13
5.7
--*
General Motors
9
7
10.2
--*
Kmart
8
10
7.3
--*
S&P 500
31 (at end 1999)
a-How long it would take for the company's earnings to increase enough at the consensus
long-term growth rate for its P/E to fall to 31 -- the year-end 1999 S&P 500 P/E ratio -- if the
company's shares stayed at their current price.
b-At consensus long-term growth rate
*-Already below S&P ratio
Source: Bridge, First Call/Thomson Financial, WSJ research
So rather than question overall valuations, investors need
to ask themselves whether they are overpaying for growth
stocks, in particular technology stocks. A good place to
start is the Internet. The nearly 400 Internet-related
companies compiled by CommScan LLC, a New York
investment-banking research firm, Friday had a market
value of $1 trillion. Their total revenue in the past 12
months was only $29.5 billion, according to First
Call/Thomson Financial data. Next year, they are
expected to lose more than $9 billion. For the same price
you could buy every energy and basic-materials company
in the S&P 500, S&P midcap and S&P small-cap index,
including Exxon Mobil, Chevron and DuPont and get
revenue of $753 billion and profit of $23 billion.
Clearly, America Online, Yahoo! and even Amazon.com
have carved out leadership positions in a rapidly growing
industry. Whether the hundreds of less-tested companies
deserve the same valuations is more contentious.
Online-grocer Webvan Group with $4 million in revenue
and no hope of profit anytime soon, is priced at $4.2
billion, more than Winn-Dixie Stores, with revenue of
$14 billion.
While growth stocks have always traded at far-higher
valuations than the overall market, such as IBM and
Xerox in the 1960s and early 1970s, never before have
companies the size of Cisco Systems (third largest market
value in the U.S. at $352 billion), Oracle ($152 billion)
or America Online ($141 billion) sold for more than 100
times trailing earnings.
"Intellectually, it is really hard to justify what has gone on
in technology," says Roger McNamee, a veteran
technology investor who is general partner at Integral
Capital Partners, a Menlo Park, Calif., investment firm.
On the other hand, their growth rates are pretty
spectacular. At its estimated long-term growth rate of
30%, Cisco's profit will double in 2 1/2 years, compared
with five for Coca-Cola and 10 for Exxon Mobil. Today's
companies can grow more quickly than their predecessors
because they are more dependent on intellectual than
physical capital, argues Michael Mauboussin, chief
investment strategist at Credit Suisse First Boston. For an
auto company to grow, it had to raise additional capital to
build factories and equipment. For a software company or
an online business to grow, it just has to print more
CD-Roms or add more accounts. Thus, assuming the
demand is there, such companies' potential growth is
unlimited, and it can come without an extra dime of
capital from outsiders. Mr. Mauboussin says these
superior economics can be seen in the higher return on
capital for the 50 largest industrial companies today: 32%
at the end of 1998, compared with 19% for the Nifty Fifty
stocks in 1972.
Even if theoretically these companies can grow much
faster than before, Mr. Hickey says the fact is many don't.
"Oracle's P/E ratio in 1990, when its [revenue] was
growing at 50%, was 50. Now its P/E is
100-and-something for 12% revenue growth. Sales
growth straight down, stock price straight up."
Judging stocks today based on their historic valuations
also can be a mistake because companies can change and
none as quickly as a software or Internet company. "All
the pundits said 18 months ago, Amazon.com has to sell
every book on the earth to justify today's value, it doesn't
make sense," says Mr. Mauboussin. "What wasn't fully
appreciated was they could take that platform and do
different things with it."
Furthermore, the potential market for an Internet or
software company is far larger than that of an automobile
or oil company, whose markets are growing no faster than
the economy. Thomas Madden, chief investment officer at
mutual-fund manager Federated Investors and former
skeptic about technology valuations, recalls being told by
a scientist from Carnegie Mellon University that if you
plotted any Internet related factor on a chart, from users to
network parts, it would be rising "geometrically," that is
in an almost vertical line. "When an investor ... begins to
believe that such growth may continue for years to come,
it is easier to withstand very lofty valuations."
Some of today's tech leaders have spent most of their
history growing in the face of doubt. Microsoft has been
overvalued compared with the rest of the market virtually
since it went public in 1986, but it consistently has beaten
expectations and today is the world's most valuable
company, and one of the U.S.'s most profitable. When
Jonathan Cohen, now an analyst at Wit Capital, began
coverage of the most-prominent Internet stocks in
December 1995 for Smith Barney, he presciently rated
Netscape a "sell" but he also rated AOL a "hold," an
ambivalence that cost dearly anyone who listened. AOL,
which was at about $2.80 split-adjusted at the time,
closed at $63 Friday.
The experiences of Microsoft and AOL are regularly
cited to justify the valuations of numerous technology
stocks today. But Microsoft enjoys a virtual monopoly on
PC-operating system software and AOL holds a dominant
market share in providing Internet service, a position it
may strengthen with its planned merger with Time
Warner. Few other companies boast similar virtues, yet
many carry similar expectations. For Yahoo to retain its
current stock price and trade at the same P/E as the S&P
500, it would have to maintain its estimated 50% growth
rate for eight years without stumbling. Stumbles happen
quickly. Four weeks after going public in the fall,
business-auction site FreeMarkets achieved a market
value of $12 billion. It lost a fifth of that in one day when
a client, General Motors, said it was shifting its business
to a competing auction site.
None of this discourages Wall Street from continuing to
sell Internet stocks and their other-worldly valuations to
the public. Some see a cynicism at work. Mr. McNamee
says many institutions, including mutual funds, are buying
into late-stage venture deals simply because they are
almost guaranteed that once the company goes public (as
most of them now do) the stock will skyrocket, adding a
pop to the fund's performance. "People have gotten
positive reinforcement for investment behaviors that are
intellectually hard to support."
Even if the market is overvalued, that alone is unlikely to
usher in a bear market. Mr. Keon notes that bull markets
almost never end simply because of overvaluation; they
need a trigger: falling earnings, rising interest rates or
inflation, or war. With the profit outlook rosy and the U.S.
at peace, the biggest threat, then, is rising bond yields as
the Federal Reserve prepares to lift short-term interest
rates to choke off inflation. By some measures, stocks are
67% overvalued relative to bond yields. Should rising
rates eventually deflate the market, the greatest risk is that
investors, who now have so much confidence in the
future, abruptly lose it.
As Mr. Greenspan noted last year, "History tells us that
sharp reversals in confidence happen abruptly, most often
with little advance notice... . Claims on far-distant future
values are discounted to insignificance. What is so
intriguing is that this type of behavior has characterized
human interaction with little appreciable difference over
the generations. Whether Dutch tulip bulbs or Russian
equities, the market price patterns remain much the same."
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