Stack: Technology Investing 101

11/15/2002 12:00 am EST

Focus:

James Stack

President, Stack Financial Management

"Will technology ever be a good investment again?" asks Jim Stack, who correctly moved out of tech stocks in 2000 and has remained bearish on the sector ever since. Now, the editor of InvesTech Market Analyst examines the current state of the market and highlights what investors should consider when evaluating tech stocks.

"Bubbles are unpredictable and while many former high flyers appear to offer irresistible value at today’s prices, investors are wise to be cautious. High valuations and volatility have always been characteristic of this sector. Justification for buying tech stocks is often based more on high growth expectations than current fundamentals. Hence, technology companies carry higher p/e and price-to-revenue ratios than the S&P 500 or old economy stocks. When expectations are for 20%+ growth rates, there’s always big room for disappointment. And any error in meeting revenue targets or new product introductions can send investors scampering for the door.

"Competition is fierce. Today, few technology companies other than perhaps Microsoft enjoy the overwhelming advantage of exclusive patents that made Xerox, Polaroid, and IBM dominant names in the 1970s and 80s. When there are a lot of players and few barriers to entry, industry leadership seems to change with the wind. In mature technology markets, growth can depend on grabbing share from competitors. For example, Dell is gradually gaining PC customers at the expense of Hewlett Packard and IBM. These competitive pressures intensify as markets like personal computers or wireless phones mature and become saturated. The results can be falling product prices and reduced profits.

"Obsolescence must be continually engineered. Many technology companies are not selling services or consumables. Instead, they sell equipment or software, which means future sales growth depends on engineered obsolescence. They must continually reinvent their products to work better or faster, which places a tremendous burden on product development. If a company falls behind in research and development, one misstep can spell disaster.

"Overall, technology investing is not for the faint of heart. Even with prices that look rock bottom after 2 ½ years of losses, the value to be found in this sector is still controversial. Historically, technology stocks have rebounded sharply in the early stages of a new bull market. However, this bear market has seen numerous rally attempts that have ended with crushed hopes – and new lows for technology investors. The ongoing washout has left the sector with saturated markets and slower growth. In addition, investors are using any rallies to sell and lessen their losses.

"In response to our initial question, ‘Will technology ever be a buy again’ – the answer is a qualified yes. There is undoubtedly more pain ahead, and other companies will follow Worldcomm through the bankruptcy route. It will be tough to pick the survivors, and an even more difficult task to find predictable growth for at least the next couple of years. Formally, we are not advocating the technology sector, although we do have some under consideration for future purchase. Below are some guidelines to help reduce the risks and pitfalls of venturing into this sector:

Don’t bottom fish just because a stock price looks cheap. Stock prices don’t make great bargains. Valuations do. Examine the underlying fundamentals, and where earnings would be if not for the impact of recessionary write-offs.

Avoid companies whose growth depends on engineered obsolescence. Search for those that derive a substantial part of their revenue from providing services of consumable products. One example is Symantec (SYMC NASDAQ), which markets virus protection software and charges annual fees to keep virus listings current.

Look for firms that have a competitive advantage and are leaders in innovation or niche markets. For instance, L3 Communications (LLL NYSE) specializes in secure, high data-rate communications which are in demand, particularly by the military, as protection against terrorist activities.

In this recessionary environment, focus on revenue over earnings. Reorganization costs and write-offs are taking a toll on the bottom line for many technology companies. Until the tough times pass, it’s more important to find companies that are managing to keep their revenue stream intact. Then look at the operating earnings (before write-offs) to see where the official reported earnings might head after a recession is over.

Be very wary of high debt levels, sudden increases in leverage, or downgrades in credit ratings. The back side of a popped bubble carries deflationary pressures that increase the burden of debt. If revenues sag and credit ratings are downgraded, a formerly healthy company with high debt can suddenly find itself in big trouble.

Keep allocations to the tech sector within reason. Gone are the days of 100% technology portfolios for most investors. They have learned their lesson. However, we suggest limiting tech exposure to 20% (and that’s a maximum). Technology adds spice which is nice in a rising bull market. But too much spice, and…well you get the message.

"Needless to say, a lot of these are tough standards to meet in the technology sector right now. For many companies, growth will remain elusive over the near term. For others, survival will beome the main objective. The key point, before stepping into any technology stock, is to set an exit strategy. Once a market bottom is in place and as the economy improves, expect technology to slowly regain its attractiveness – but without the unrealistic expectations and inflated valuations of the bubble years."

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