This is a good response to the negative Barrons article:
" FeaturesTech Made EasyLook for monopolies, man, and bargains and
fundamental strengths to build a portfolio in this essential sectorAt
the end of 1997, the news for the technology sector--which includes
semiconductors, computers, communications, software, bioengineered
drugs, and medical devices--had rarely been worse. With the economic
disruption in Asia, most of the industry was suffering, many companies
having lost 30 to 50 percent of market cap in a couple of months. The
outlook for the next few months didn't seem much better. Oracle missed
its second-quarter earnings of fiscal 1998 by 4 cents and got pounded.
Two days after the announcement, the stock, which had been at $32.38,
was down 27.6 percent to $23.44. Oracle president and chief operating
officer Raymond Lane said, "The Asian crisis isn't going to be rapidly
absorbed, and one must expect to suffer the consequences for another six
months."So why a cover story now on buying this risky sector? Because
it's time to plan ahead for your next acquiring opportunity. We're not
talking buying on the dip. We are talking about technology being the
dominant growth area of the economy in the foreseeable future, and an
essential part of your portfolio. The hard part is figuring a smart,
disciplined way to get the growth and manage your risk.How to begin? Get
the Monopoly game out of your closet. Most of us will never be able to
understand all of the science behind the hottest microchips,
communications tools, bioengineered drugs, and medical devices, but if
you love the thrill of controlling Park Place and Boardwalk, you know
what it feels like to own a great technology stock. "It is the
technology-based monopoly and the profits that can follow from it, and
not merely the technology, that should attract you as an investor," says
fund manager and Forbes columnist Michael Gianturco in his book How to
Buy Technology Stocks (Little, Brown).Gianturco says the idea goes all
the way back to the network of roads within the Roman Empire. By
controlling its military highways, the Roman Empire held sway over
commerce, the comings and goings of its citizens, and ultimately its own
safety from invaders. Any firm with a secure network--an idea that
includes patents and proprietary knowledge--is essentially a toll taker.
It can cut off competition and charge any price the market will bear.
And the person who becomes the real estate czar in Monopoly, as you
know, can just sit back and bleed all the other players in the game.
Given the great weight of this historical example--and board-game
strategy--is it any surprise that Microsoft and Netscape are locked in a
bloody battle over whose browser will triumph as the gatekeeper to the
Web? "The nature and controllability of the network is the first thing
you must consider in evaluating any technology stock," Gianturco writes.
"Only in the context of a network will the numbers make sense."With
patents or proprietary knowledge, firms can create giant money machines
by introducing products that literally transform the economy, in big and
small ways. You don't need to look any further than Forbes' annual
listing of the 400 richest Americans to see that the Carnegies, Morgans,
and Rockefellers--gentlemen who controlled the most important sectors of
their day--have been succeeded by Microsoft's Gates and Allen, Oracle's
Ellison, and Intel's Moore, a new generation of entrepreneurs who
understand the value of having fences around their franchises.The
advantage you have in searching out the new gatekeepers as an individual
investor is that, unlike fund managers, who are in a constant
performance derby, you can think long-term rather than worrying about
every rise and fall in the market. In another recent book, Every
Investor's Guide to High-Tech Stocks and Mutual Funds (Broadway Books),
Michael Murphy, who has earned fame as the publisher of the top-ranked
California Technology Stock Letter (www.ctsl.com), likens your position
to that of a baseball batter without a ball and strike count--you can
wait and wait until you get the pitch you want. For tech investors, it
frequently means waiting for a fair price. In the meantime, the trick is
to create a list of great companies that you'd love to own if the price
were right. It may take several years of thorough research and
disciplined buying to build a diversified portfolio of technology stocks
in both electronics and biotechnology. But when you're done, depending
on your age and tolerance for volatility, you'll have between 10 and 70
percent of your equity holdings in 10 to 20 tech stocks.Building this
kind of portfolio is a multistep process. First, find the best of the
best, companies that have a proprietary advantage and appear to have the
ability to sustain it. You can narrow your choices considerably by
taking a hard look at their numbers, like the ones provided in the
chart. The second step is to make sure that no matter how much you like
the stocks, you don't pay too much for them. Then third, integrate the
stocks into a diversified portfolio that will help minimize some of the
risks. And it is always important to know how and when to sell.Testing
the StocksThe companies that will eventually make it onto your list need
to pass a few tests, similar to those suggested by Murphy. First, any
candidate should have a market capitalization (shares outstanding times
current share price) greater than $25 million. This will exclude micro
caps; in all likelihood, our search for dominant firms will exclude most
small caps as well as the smallest mid-caps. Small stocks make great
investments, but to reduce the volatility of your portfolio, you want to
limit your tech holdings to companies with the funds to finance new
ventures, survive a mistake, or fight to defend their market share.Then
check out the sales figures. Annual sales should be growing at more than
15 percent. In the current slow-growth economy, this is tough. A firm
really needs to have an interesting product to grow three to five times
faster than the economy. So a healthy growth rate is one signal of
market dominance.But all of the sales and cool developments in the world
don't mean anything if the company can't sell its products at a profit.
The next test is to compare the company's earnings with its sales. If
you find low earnings--say $5 million, compared with $500 million in
sales--the firm probably has one of two problems. The product may not
have much of a competitive advantage, so the company can't sell it for
much more than it costs to produce. Or the product might be dynamite but
is produced by a company that is inefficiently managed or has poor cost
controls. Firms that have high profits in relation to their sales may be
extremely well managed but may not have a product that is all that
special. As long as you confine your search to high-sales-growth
companies, you don't have to worry as much about the companies with good
management but a mediocre product, so you can go ahead and require high
profit margins.A third measurement to watch is the firm's return on
equity (net income divided by stockholder equity), or ROE. ROE is a way
to measure how much growth a company can finance without having to issue
more shares--which would dilute the value of outstanding shares--or
borrow money, the servicing of which would reduce earnings. ROE is also
a way to measure how hard the shareholders' money is working. Again, 15
percent is a good cutoff.To make your search easier, we used the
Bloomberg database to find 36 stocks that meet these criteria and listed
many of their growth rates and ratios. Over the next several months, as
firms release new financial statements, you can download them from the
SEC's EDGAR database of corporate information (www.sec.gov); read
Hoover's on-line, at www.hoovers.com, to get an idea of what these
companies do; look up the companies' own Web sites; read their
descriptions on the Bloomberg Web page (www.bloomberg.com); and check
the analysis of First Call on the personal-finance channel of America
Online (or at www1.firstcall.com) to see what analysts think about the
firm. Microsoft Investor, at investor.msn.com, also offers some very
useful tools for analysis.Slimming the ListTo get into the universe of
these 36 tech stocks, a firm had to be spending at least 7 percent of
its revenues on research and development, to build and maintain its
dominance. If a company isn't devoting at least that much of its sales
or even more on R&D, throw it off your list. "Accountants do not require
managements to break out R&D as a separate line item if it is not
significant," Michael Murphy says, "and below 7 percent, many companies
seem to feel that it is not significant. We agree!"But make sure the R&D
isn't being wasted. You can get a bead on this by calling the investor
relations department at a company and asking what percentage of its
current sales are coming from products that have been introduced in the
past three years. The answer should be more than 50 percent. If the
percentage is less than that, the company doesn't belong in this elite
group. (It is also important to put the size of R&D spending into
perspective: 8.6 percent of Intel's 1996 sales paid for $1.8 billion
worth of research--a lot more research than the $400 million that came
from 20.5 percent of Advanced Micro Devices' sales.)Why should investor
relations even bother to have this discussion with someone who is buying
less than 1,000 shares? The answer, according to Murphy, is that many
companies prefer to have more than half of their shares in the hands of
individual investors. Small stockholders are more likely to be long-term
holders and less likely to head for the exits if the stock misses
earnings estimates by a penny. Murphy says that Intel made a conscious
effort to increase individual ownership from 30 to 50 percent between
1993 to 1996.While you are building your wish list, determine the firms'
debt-to-equity. Debt is a dangerous thing in tech industries; it gobbles
up earnings, and in tough times, it marks either the company's coming
insolvency or the time when it will need to sell more shares. You can
also look at the amount of cash and marketable securities the company
has on the balance sheet and compare this with the change from the
previous quarter. Divide the total cash and marketable securities by the
amount of cash the company has been burning through, and you can make a
pretty good guess at how many quarters the company can last without
resorting to either equity or debt financing. In many cases, the company
will be bringing in more cash than it can spend, a condition that shows
up at the bottom of the cash-flow statement. When you see that, you know
you are getting warmer.By looking at the inventory turnover (cost of
goods sold divided by the average of beginning and end-of-the-year
inventories), you can determine if products are moving out the door. It
can be a danger sign when a firm's stock of raw materials and finished
goods balloons. Microsoft actually has no inventory, which is a very
good sign. Inventory is a real disaster in technology businesses. What
do you think a warehouse of computers with 386 processors is worth? How
about software that doesn't run on Windows 95? Dell Computer is a
shining example of a company the market has rewarded for improving its
inventory situation by shifting its production system to build-to-order.
In 1993, it took Dell 50 days to turn over its inventory; by 1995, it
was down to 34 days. In November 1997, Dell's build- to-order business
model was humming along, and the firm was turning inventory over every
11 days, compared with slightly less than once a month at Compaq.
Accounts receivable turnover (net sales divided by average accounts
receivable) measures how quickly the company's customers are paying
their bills. Microsoft has turned over its receivables 14 times a year;
that's pretty good, if you figure that 12 times means that customers are
paying their bills in 30 days. You really have to be impressed with the
fact that buyers want or need to do business with the company badly
enough to pay up in record time. This is highly dependent on the
industry and even the season, but six times is a good benchmark.Setting
Your LevelHaving vetted your companies, you should turn your attention
to buying at attractive prices. Time after time, stock
prices--especially in the tech sector--are driven by greed and fear. By
understanding a thing or two about valuation (or the price you can pay
for a company and still have a chance of making money, even if things
don't work out perfectly), you can save yourself some heartache. Iomega,
maker of Zip drives and disks--which are about the same size as a
conventional disks but have over 70 times the storage capacity--is an
example of the perils of investing without attention to valuation.
Between May 1996 and May 1997, the stock plunged from a split-adjusted
$27 to $8.50, even as sales and earnings increased. The problem was in
the valuation. At its peak, the stock traded at 1,666 times earnings
(surely the devil's work). When the company could not match Wall
Street's expectations about future earnings, disaster followed.Valuation
isn't an exact science, but as a general rule, high valuation is a sign
of high optimism. There are two ways to approach valuation: The first is
to look at the price versus various figures, like earnings, sales, and
book value. The second is to try to determine what the rock-bottom share
price of each of these companies is likely to be, based on valuation
levels where tech stocks have stopped falling in the past.The first
measure Murphy uses to find attractively priced stocks is what he calls
price-to-growth-flow ratio. You calculate it by taking the current stock
price and dividing by the sum of earnings per share plus R&D per share.
Murphy says, "Anything under 8 times starts to get my attention,
and...under 2 times [makes me] mortgage the ranch."Another thing that
you can do to choose between stocks is to try to figure out which one is
likely to fall the least. That value, called the downside-risk
value--the price at which a falling stock will begin to attract buyers,
based on Murphy's experience--is the average of three calculations. The
first is sales per share multiplied by one; Murphy says that this is a
point where many companies will start to attract buyers. The second is
the book value times 1.5. And the third is earnings per share times
one-third expected long-term growth rate (you can find the growth rate
from First Call in its earnings reports on AOL). Add these figures
together and divide by three, then compare the resulting average with
the stock's current price to get an idea of what the downside is.But
even that is nothing you can bank on. Stocks can and do fall through
this support level like a hot knife through butter. Apple Computer, for
example, is worth $56.17 based on one times sales per share; it's worth
about $12.32 based on 1.5 times book value; give the company a goose egg
for the third criterion, and you have a stock trading at $13.13 whose
"floor" is $22.83. Netscape is a $24.38 stock with a floor of about $4,
and Yahoo! is a $63.44 stock with a floor of about $1.50. Those figures
will give you a sense of where the ground floor is. On average, the
blue-chip tech stocks are trading at about 40 percent above this floor.
What good is the downside-risk value if stocks can fall through it? "It
gives us some comfort that if things don't work out, there may be a
corporate buyer at or near our cost," Murphy says.Mortaring Them
TogetherSo you have information on a number of companies and a pretty
good framework for understanding their businesses, how they stack up
against their competition, and what their valuations look like; now you
can start making your purchases and building your portfolio. Academic
research suggests that you can get pretty decent diversification by
owning eight stocks. Although Gianturco suggests doubling it to 16
because of the sector's unpredictability, Murphy thinks that you can
begin with as few as four--two in computers and electronics, and two in
medical technology.These sectors each perform well at different points
in the economic cycle. "Digital stocks are passengers on the economy,"
Gianturco says. "If you're expecting the economy to slow down, we prefer
the biotechs, since they're driven by discovery and not economic
activity." Although Gianturco believes in balancing medical- and
computer-related stocks to reduce volatility, he has been out of the
so-called digital stocks for over a year.The main rule of thumb is to
make sure that you strive for diversification. So if your first
computer-related pick is a software stock, you should make sure that the
second is a hardware stock. Likewise, if you decide on a smaller company
first, choose a larger company next. On the medical side, try to match a
biotech stock with a medical equipment stock, or an early-stage company
with a more mature company.Once you have four companies, your next goal
is to raise the number to 10 over time. And as you add companies,
remember: Be disciplined. Only buy when a fantastic opportunity arises,
and try to diversify your holdings with each successive purchase. The
bottom line, according to Arthur J. Bonnel, manager of U.S. Global
Investors' Bonnel Growth Fund, is that you "need to be cold-blooded."
Bonnel creates a checklist of pertinent information for all of the
stocks he owns, and he uses it as a tool to block out day-to-day noise
and focus on long-term fundamentals. "You make more money with patience
than brains," he says.You can create an additional level of protection
from the sector's volatility by holding both electronics and medical
stocks. By doing this, you are taking advantage of the fact that the
electronics stocks get more attention when the economy is booming and
medical and drug stocks get more attention when the economy is slow.
That's because people need medical treatments even when the economy
isn't booming--yet, they will often delay major purchases of business
and personal computers.The maximum number of companies you want to own
is 20, according to Murphy. Beyond that level, you are diluting the
power of your disciplined stock picking. Once you are up to around 20
companies, think about selling companies in order to make room for new
purchases. The best way? Constantly rank your holdings from strongest to
weakest based on their earnings, valuation, and the likely fruits of
their R&D. Ranking holdings according to strength is a strategy that the
Brandywine Fund has used to produce great returns and avoid losses, even
in nasty years like 1987, 1990, and 1994. Frequently assessing your
holdings keeps you sharp on their fundamental conditions.Here are some
factors that should lead you to lower a firm on your rankings or to
raise a flag about selling. You really only want to sell when the firm's
monopoly is in trouble. Dancing from one stock to another is a
prescription for mediocre returns. One thing that worries Murphy is when
the price to growth flow is equal to the growth rate, a sign he takes to
mean that the company is fully valued. Another indicator: P/E relative
to the long-term expected growth rate for the company. (You can find
this information on AOL's personal-finance channel and on Microsoft
Investor's new stock pages.) Strategists Melissa Brown and Claudia Mott
at Prudential Securities have found that when the P/E is higher than the
growth rate, your odds of success begin to decline. At this level, a
company's bright prospects are well recognized by the market, and the
risk of a major disappointment can be considerable. If the stock seems
very highly valued, you need to ask yourself if there is a company with
similar dominance that you can buy cheaper. In many cases, the answer
will be no. But you need to remember that you aren't married to these
stocks. There will occasionally be instances when the stock price is
much higher than you can justify. In that case, take your profits and
smile.Do you see a lot of short-selling activity? Many people think a
high level of short selling is good because everyone who is short will
eventually need to purchase the shares. Murphy disagrees. "Academic
research shows that short-sellers do their homework," he says. When the
short-interest ratio is greater than 15 to 25 times a company's average
daily volume, it is a serious warning. Barron's devotes several pages of
its Market Week section to listing short interest.Ultimately, though,
both buying and selling come back to the monopoly. The tech market is
going to have big swings from time to time, but as long as the tech
revolution remains intact--and it is likely to for years to come--
companies with a dominant market position, an effective research
department, and a clean balance sheet will make the most in rising
markets and fall the least in down markets. If you can research and
build a diverse portfolio of stocks and have the courage to ignore all
but the few, most wonderful opportunities to buy and sell great
companies at great prices, you should be able to outperform the S&P for
years to come.
--Christopher Graja is the author, with Elizabeth Ungar, of Investing in
Small-Cap Stocks, (Bloomberg Press). Andrew Treinen provided chart
research and additional reporting.Click here to see the Thirty-Six that
Passed the Tests." |
