January 4, 1998
A High-Technology Enthusiast Goes to the Mat
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The New York Times on the Web: Cybertimes
By MARCIA VICKERS
echnology is in a slump. Wall Street has been getting nervous about the sector, and it has been hit hard by the Asian
crisis. But Michael Murphy, long a fan of the field, is as high on it as ever.
Murphy, founder and editor of the California Technology Stock Letter and author of "Every Investor's Guide to
High-Tech Stocks and Mutual Funds" (Broadway Books, $27.50), to be published this week, contends that technology's
recent troubles are due to misconceptions, not fundamentals.
From his offices in Half Moon Bay, Calif., Murphy, 56, argues that most investors are seriously underweighted in
technology, which is the main sector in what he calls the "new economy," and seriously overweighted in the venerable
corporations of the "old economy."
Indeed, rather than allocate assets only according to stocks, bonds and so forth, Murphy would do so by "new economy"
holdings and "old economy" holdings.
Recently, Murphy who manages individual portfolios and three mutual funds that specialize in technology, discussed how
to do research in this complex but undercovered field, how to pick winners and how to limit the industry's high risks.
Q. The technology sector finished 1997 down nearly 14 percent from its yearly high. Do you think that presents an
opportunity?
A. Yes. I take very seriously what's going on in the Far East, but I think Wall Street's got it backward. The companies that
are hurt the most are those that depend on consumer sales there -- soft-drink companies, tennis shoe companies, airlines.
The effect on technology is rather limited. Yet that's been one of the groups that's been devastated by Wall Street.
Q. Why?
A. Wall Street looks and says: "Gee, there are problems in the Far East. Who does business in the Far East? Let's sell their
stock." A lot of semiconductor companies, for example, make chips here, ship them to the Far East to be assembled and
then they come back into the United States and are put into computer or communication systems.
But why would it hurt these semiconductor companies to have these countries' currencies collapse? After all, production
costs are lowered.
Of course, semiconductor equipment companies do sell a lot of equipment to Korean and Japanese semiconductor
manufacturers. But think for a second about how you would get yourself out of this mess if you were in one of these
countries. You would not build ships and automobiles and tennis shoes. That's where the excesses are. Instead, you'll focus
on businesses with double-digit growth. That's basically technology; there's nothing else growing that fast.
Q. So there must be other factors at play in the technology slump?
A. I think it's all psychology at this point. For example, there was a fear that personal-computer sales would not grow at all
in the December quarter, that they'd be flat versus last year. That fear was expressed in a lot of Wall Street reports.
Well, it's now clear that we're going to be up 15 percent in terms of dollars, 18 percent in terms of units, in the quarter, just
like in every other quarter in 1997. And for 1998, the lowest forecast I've seen is 13 1/2 percent. So I think it's a great time
to be buying these stocks.
Q. How fast is the technology sector growing?
A. About 20 percent a year, right now. And because it's been doing that for a while, it's up to about 15 percent of the total
economy.
Q. You've said that Wall Street is sometimes lazy when it comes to covering technology. Why is that?
A. More than 90 percent of analysts are still covering the old economies, either the old mass-production economy, which is
where most of the big, comfortable corporate names are, or the even older industrial economy. The reason -- I'm a little
cynical, I guess -- is that Wall Street puts its research where the investment banking fees are going to be. And most
technology companies are like Microsoft: They do one public offering, once. They don't do secondary offerings. They don't
raise a lot of capital. They may occasionally do an acquisition, but not many; a lot of the growth is internal.
As a result, there are a lot of technology companies out there, even with market capitalizations of $100 to $200 million, that
have very little or no coverage.
Q. Then how should the average investor get technology information?
A. These are the best of times for the average investor on that score. Because they don't get coverage from Wall Street, most
of these companies now have Web sites where their public-relations firms have written a corporate overview that gives you
a lot of the basic facts. All the press releases and the numbers will also be there. The companies have really helpful
investor-relations people, too.
The reason for all this help is that technology companies really want individual stockholders. They feel too exposed when
their stock is 70 percent or 80 percent held by institutions and all those institutions are listening only to two analysts. You
know, one of them might wake up in the morning a little grumpy and there goes the stock price, down 30 percent.
Q. How do you define technology enterprises?
A. The key differentiator for technology companies is that they spend a lot of money on research and development. We like
to see them spend at least 7 percent of annual revenues on R&D. The reason R&D is important is that by creating new
products a company helps create its own demand. Nobody knew they had to be on the Internet five years ago. But now it is
available and now people believe they have to be on it.
Q. How can you tell if R&D money is being wasted?
A. There are a couple of ways. The first is the common-sense test. Here's a wonderful example. Some years ago, a company
was working on doing electrocardiograms of dogs over the telephone. This thing had a $60 million marketing capitalization
when it went public, and they'd only done about seven tests. In this system, you called up and gave them your Visa card
and they sent you a couple of little rubber cups and you put one over the phone and one over the dog and dialed a special
number. I mean, there is a product and they were spending a lot of money on it, but it was just stupid.
Second, if the company is spending a significant amount of money on R&D, ask the investor-relations person, "What
percentage of your revenues come from products you've introduced in the last three years?" That number ought to be about
50 percent. If not, then you've got a legitimate question to ask.
This is IBM's problem. It spends more on R&D than anybody else -- about $6 billion a year -- and yet far less than half of
its revenues come from new products.
Q. Explain growth flow -- your method for picking technology stocks.
A. Growth flow is similar to cash flow, a concept people are used to. Cash flow is earnings plus depreciation, and the
reason you care about it is that both earnings and depreciation belong to the shareholders.
In an old-economy company, there is a lot of depreciation. But most technology companies don't have a lot. What they do
have that would be an expense, but is really an investment for shareholders, is R&D.
So if you add earnings per share to R&D per share you get growth flow. And the advantage of it is that the ratio of stock
price to growth flow will tip you off that a stock is cheap before the price-earnings ratio will. And you'll have enough time
to go in there, see if they're doing all that R&D on something of interest to you, if the management is able, and so on.
Later, when the R&D results in new products and the new products result in an increase in earnings, Wall Street will pile
on because, of course, they only look at earnings.
Q. What are some good growth-flow companies?
A. LSI Logic is a semiconductor company that has had earnings of about $1.15 a share for the last 12 months. The R&D per
share is $1.30 -- they actually spend more on R&D per share than they're reporting in earnings.
The management could slash the R&D and report much better earnings, and Wall Street would undoubtedly run the stock
from where it is today, which is about a little over $20, up to $30.
But that would be a very short-term thing to do. Instead, LSI Logic will invest the money, produce new products and drive
up earnings. The stock's going not only to $30, but to $40 or $45. We actually have a target of $50 for that stock.
Many other companies that are dominant in their niches are spending more or almost more on R&D than they report in
earnings. They include Credence Systems, which makes semiconductor testers; Adobe Systems, the software company, and
Diamond Multimedia, which makes add-on boards for graphics and modems for computers.
Q. How can investors avoid the dogs out there?
A. There are a couple of ways. You can just say: "Look, I don't have enough time to do this full time. I'm just going to focus
on the very best companies -- the Microsofts and Cisco Systems and Oracles and Intels." But instead of buying them at
whatever P-E they are and getting killed on the stock price, buy them only when they're down. Of that list of maybe 100 or
120 companies that qualify as great growth-flow technology companies, it's amazing how many of them will have a time
when they get cheap because they maybe missed a quarter's earnings by 2 cents a share or Wall Street gets worried about
Korea or whatever.
Q. If you own a technology stock, how low should it go before you bail out?
A. Well, you can say: "I'm a long-term investor. As long as the growth-flow numbers look attractive, I'm staying." Or use a
mechanical approach and say, "If this stock goes down 20 percent, I'm going to exit on the theory that somebody knows
something I don't know or something was wrong with my analysis." I wouldn't use 15 percent; I think it's too tight in a
technology company. Then wait until the stock bottoms and, once it starts to lift, go back in it if you still want to be
involved.
Q. Do you have any advice for investors who like technology stocks but find them too volatile?
A. There are a couple of things you can do. Instead of owning tech stocks, you could own tech mutual funds. That would
spread the risk somewhat. Or you can buy technology convertible bonds. Convertibles have about half the risk of the
underlying common stock and they give you about 85 percent of the return that the stock will give you.
Third, don't buy all the same types of stocks. If the first stock you buy is in semiconductor equipment, maybe the next
should be in software. And if those first two are roughly in the electronics area, maybe the third should be biotech. When I
started following these stocks in 1970, it was the mainframe computer business and they pretty much all moved together.
Now, there's much diversity.
Q. Are you particularly bullish or bearish on any sector?
A. The area we're most bullish on is semiconductor equipment, just because the stocks have been hit so hard. We're bullish
on biotechnology, too, because it is finally to the point where a lot of products are being approved. Through 1994, three
biotech products a year, on average, were approved. In 1995, it jumped to six. In 1996, there were 13; in 1997, almost 30. In
1998, we're going to be at 50.
We're not terribly bearish on any sectors, but we are most negative on the Internet infrastructure software companies --
even though we're big believers in the Internet in general. Most infrastructure companies, which make the browsers and
servers and fire walls, are not making money yet. It's a very competitive area, too, with every graduate student in computer
science wanting to be the next Marc Andreessen and start the next Netscape.
Q. How should the average investor get started in technology?
A. Put some money into a biotech fund, a broad-based tech fund and then maybe some into a specialty fund that's done
well, say one of the software funds or telecommunications funds. If you only want mutual funds and not individual stocks,
that's fine. The big driver for future rates of return is what percentage of your assets you put into this area.
Think of it as asset allocation. People think now in terms of stocks and bonds and cash and maybe real estate or foreign
stocks. I think you really have to think of it in terms of old-economy and new-economy stocks, bonds, cash and so forth.
And make a decision on what percentage of your assets is going to be in these new-economy stocks. The last change like
this was in the early 1900s. The people who earned the really high returns recognized that the new economy was under way
and shifted assets into that area. |
