|If there is an economic recovery going on, has anyone told the technology sector? The conventional wisdom on business cycles suggests that when the economy gets moving up and out of recession, one of the first groups to benefit is the technology sector. Why is this so? Generally, the technology sector — including everything from communications technology to semiconductors to hardware and software — is sensitive to changes in both gross domestic product (GDP) and capital spending. When GDP begins to grow in the wake of a contraction, and capital spending — perhaps resuscitated by lower interest rates — also starts to increase, the technology sector has an easier time selling its products and services to businesses, as well as funding its own research, development, and expansion efforts. With reports that the US economy grew more than 5% in the first quarter of 2002, many of those technology analysts who warned investors that tech was "too low to sell" months ago have begun to announce that technology companies will soon be on their way back. |
Unfortunately, as Donald Luskin, chief investment officer of TrendMacrolytics, has noted, the captains of the technology industries do not seem to share the optimism of the technology analysts. Luskin writes: "Listen to what the CEOs and CFOs of virtually every big technology company have been saying at virtually every conference call this earnings season: 'We don't see any signs of recovery, and we can't guide beyond the next quarter.'" Luskin's point emphasizes that this is not just a clever corporate attempt to engineer an upside earnings "surprise," but a real admission that the technology sector is not rallying back, even in an economy that grew more than 5% in the first quarter of 2002.
Luskin's concerns are particularly focused around the still-lofty valuations of technology companies — a fancy way of saying that technology shares are overpriced compared to the profits that investors are expecting from these companies. As Luskin and others looking at technology company valuations have noted, the forecast for Intel's basic earnings per share (EPS) in 2002 is about $0.68. This is midway between Intel's EPS in 1995 ($0.54) and 1996 ($0.78). Yet, because Intel's share price was only $7 at the end of 1995 and $16 by the end of 1996, shares of Intel featured a relatively modest P/E ratio of 13 in 1995 and 21 in 1996. This compares to Intel's recent price of $30.53 with a P/E of 45 — more than double its 1996 valuation, and three and a half times its 1995 valuation.
IN THE BOOM/BUST ROOM
Finding value in technology investments has thus become increasingly difficult for real-world money managers like Tom Laming, chief equity strategist and portfolio manager at Buffalo Mutual Funds. This is partly because one of the main ways of accomplishing this — that is, snapping up the smaller technology companies with strong growth prospects — no longer seems to work. As Laming's research suggests, this difficulty is less about a temporary lack of small tech companies that do not already have large, unwieldy institutional followings and more about a real, secular change in the technology sector.
As Laming notes: "Today, more than in the past, size is impacting the type of technology companies in which we can invest. Entry barriers [have] become very large-scale . . . very important and being a larger company . . . [is] essential to profitability." It is this new reality (the "New New New Thing"?) that has many savvy money managers and market analysts believing that the quest for "the next Cisco" is a doomed one, and that the days of explosive small-cap growth in the technology sector may have come to an end.
In his white paper, "Small Versus Large Technology Companies: How Company Size Is Impacting Current Investment Opportunities In Technology," Laming points to three main problems facing smaller technology companies. First mentioned is the dearth of quality in the initial public offerings (IPOs) of the 19962001 period. While the high-profile implosion of the dotcom industry in the spring of 2000 tended to catch investors' attention, the same often-reckless venture capital that funded the likes of Pets.com (remember everyone's favorite sock puppet?) also funded "Internet appliance" companies such as ePods, companies based on free operating systems such as Caldera Systems and VA Linux Systems (which soared an eye-popping 700% on the afternoon of its IPO in late 1999), and any number of companies dedicated to providing cheap broadband connections to businesses and consumers.
Interestingly, Laming compares this period with the personal computer (PC) boom and bust in the early 1980s, a period in which "it seemed that every start-up with a new design for a personal computer, a new word processor, or a new disk drive was receiving funding. With too many companies chasing limited end markets," he observes, "a consolidation period ensued, resulting in many mergers and bankruptcies."
While this period of consolidation was likely a plus for the long-term success of the technology industry (in PCs, for example, the 198385 period coincides with the development of Microsoft's Windows operating system and the victory of the GUI, or graphic user interface; Time magazine named the PC its "Man of the Year" in 1983), it also meant a great deal of suffering for many of the smaller technology companies that were squeezed out. BusinessWeek in its April 2, 2001, cover story referred to the 1985 "tech meltdown," noting that "back then, most bloodshed centered on the PC. There were 30 PC cloners and more than 70 disk drive companies, many of which vanished when supplies ran ahead of demand." The story continued, "The deadly combo of slumping demand and excess capacity set off fierce price wars as rivals fought to retain market share."
Laura Walbert, writing in the Forbes 1984 Annual Mutual Fund Survey, observed of tech investing:
It almost always happens that way. A tiny fund scorches the track, brings in big money and sends late investors into the tank — From inception (July 1981) through June 1984, [Fidelity] Select Technology can claim an attractive compound annual return of 27%. But this in no way represents what an average investor in the fund earned. In dollars, Select Technology's losses in the year beginning July 1, 1983 (investing exclusively in technology stocksmany of them small ones) far exceeded all its gains in its preceding two years of existence.
Sound familiar? See Figure 1 for a chart illustration.
Figure 1: From the summer of 1983 to the summer of 1984, the Fidelity Select Technology Fund lost more than 30%.
Another source of difficulty for smaller technology companies in the current environment is the semiconductor industry itself and the greater amount of capital needed to compete. This is one of the areas where the issue of scale is most stark. As Laming notes, "The cost of a single wafer fabrication plant for memory and microprocessor products now approaches $2 billion." Business and personal computer consumers have enjoyed the productivity premium that comes with things like Moore's Law, which suggests that the number of transistors per integrated circuit (a fancy way of referring to the efficiency of processing power) would double every 18 months. But these leaps in productivity often came at the expense of smaller companies unable to keep up with the Intels and Motorolas, who themselves were struggling to keep up with competition from Japanese firms back in the 1980s.
One of the most interesting examples of this problem for smaller technology companies is Transmeta. Founded in part by Linus Torvalds, inventor of the free computer operating system called Linux (which was growing dramatically in popularity at the height of the dotcom boom in 2000), Transmeta was shrouded in great secrecy in the days leading up to its IPO in early 2000: What was Transmeta's product? What was the genius of Linus Torvalds contributing to this mysterious effort? And, of course, where can I get some shares before the IPO launch? Notwithstanding the epic secrecy and levels of hype that were unusual even for the dotcom era, Transmeta's product — a sort of state-of-the-art emulation (code translation) involving a central processing unit (CPU) and "code morphing" software — was, on balance, a worthy innovation.
But the problem, as Laming notes, was not in the innovation itself, but in the production. Laming writes: "The problem for Transmeta . . . is similar to what would be encountered by a new small company attempting to compete with General Motors and Toyota. The company might be able to design a competitive model, but the capital required to profitably manufacture millions of cars per year would be prohibitive." Further, Laming notes, Transmeta's revenue for Q4 2001 was about $1.5 million compared to nearly $7 billion for Intel, with whom Transmeta competes. In addition, Intel spends in excess of $10 billion each year on its manufacturing facilities — including research and development — a sum Transmeta could not hope to match. As Laming concludes: "There are reasons there are no small-cap automobile manufacturers, and the same reasons appear to be impacting parts of the technology industry today. . . ." (See Figure 2.)
Figure 2: The bear market in the Nasdaq from 1983 to 1984 helped spur consolidation in the PC and disk-drive industries.
FROM "TAG" TO "KING OF THE HILL"
While the previous factors — poor IPO quality and the capital requirements of the semiconductor industry — are a part of the theme of the maturation of the technology sector, this issue of maturity is worth exploring in its own right. Some of this has to do with changes in the technology industry itself. Whether the changes have to do with the migration from mainframe computers to minicomputers to microcomputers to PCs and handhelds, or with the growing emphasis on the role of software (Transmeta's processor was hyped for a while as a "software-programmable CPU"), invariably, the companies that succeeded at one stage faced increased challenges in both anticipating the direction new technologies would take (recall Microsoft's early disregard for the Internet) as well as in developing the right products that would take advantage of the new technology.
Unfortunately, what begins as a game of "tag" — in which new companies try to pin "obsolescence" on their often bigger and older competitors — turns into a game of "king of the hill" once the inventories begin to pile up and service contracts stop being renewed. Clayton Christensen, in his must-read text The Innovator's Dilemma, underscores the ability of smaller, legacy-free companies to deploy new technologies to the detriment of older, established firms in good times. But during this particular "consolidation phase," Laming notes that the pressure will be on the smaller companies, not the larger ones, particularly those "that lack the balance sheet strength to survive the weak earnings environment that usually characterizes such a period."
What's worse for many of the smaller companies, many of whom, in effect, were simply jumping on a PC or broadband or microprocessor bandwagon, is that the decline in business on the margin (the more high risk/reward ventures) increases the incentive for companies to compete over the little business that remains. The problem with this, of course, is that there is rarely room for more than one or two dominant players. As Laming suggests, looking at the network equipment market, "Recent sequential revenue growth at Cisco Systems suggests the rapid growth of Cisco's already large market share versus smaller competitors. . . . The longer the current downturn in demand lasts, the stronger Cisco's position within the industry will become." It is from this conclusion that Laming asserts, "Asking 'Who will be the next Cisco?' is meaningless if companies are trying to compete with essentially undifferentiated 'me-too' products, and in effect, trying to 'out-Cisco' Cisco."
BUYING "BALANCE SHEET STRENGTH"
These conclusions have helped Laming steer Buffalo Mutual Funds away from small-cap technology companies and closer to mid-caps and selected techs (Buffalo launched both a mid-cap and a science and technology mutual fund in 2001). But what can individual investors learn and apply? For one, individual investors can consider following Buffalo Funds' lead by reexamining portfolio allocations to see if technology stocks are (still) overrepresented. If they are, particularly close attention to any small-cap technology shares would be in order.
But should investors limit their scrutiny to small-cap technology shares? Some of the threat to small-cap technology companies from large-cap techs is eerily similar to the hazard that large-cap stocks in other areas pose to their small-cap counterparts, be they in transportation, consumer cyclicals, staples, or financials. Here, the advantage for large-cap funds vis-a-vis small-caps is what Laming refers to as "balance sheet strength." Even as the share price of companies like Microsoft fell in the first stages of the bear market in 2000 and 2001, few worried about the longer-term prospects for the company because, among other reasons, Microsoft was flush with cash. It is this cash that enables companies like Microsoft and Cisco (and, by extension, companies like Home Depot and Wal-Mart) to engage in the market-share capturing maneuvers that their smaller, less cash-rich competitors cannot.
This, of course, does not mean that all small-cap stocks are worth avoiding. Small-cap stocks in sectors and industries that are experiencing strong growth — such as health care, where hospitals and medical devices have outperformed the rest of the market for two years — can still be valuable small-cap holdings. But always remember that small-cap stocks are built for growth, and if the sector these stocks represent is not itself growing strongly, the stocks can hardly be expected to outperform on their own. In such a scenario, large-cap stocks offer — if not spectacular growth — at least the security of investing in what TheStreet.com's Jim Cramer occasionally refers to as "share-takers."
As Laming concludes on behalf of the blue chips: "The changes we see taking place within technology should equate to positive opportunities for many companies. . . . The problems we see for some small technology companies . . . should accrue as incremental profits for the mid- and large-sized technology companies we own."
David Penn may be reached at DPenn@Traders.com.
SUGGESTED READINGBurrows, Peter, Jim Kerstetter, and Linda Himelstein . "Surprise! The Tech Industry Is Cyclical," BusinessWeek: April 2.
Christensen, Clayton . The Innovator's Dilemma: When New Technologies Cause Great Firms To Fail, Harvard Business School Press.
Laming, Tom . "Small Versus Large Technology Companies: How Company Size Is Impacting Current Investment Opportunities In Technology," Buffalo Mutual Funds white paper.
Luskin, Donald . "The Nasdaq's Wyle E. Coyote Recovery," Market Calls, TrendMacrolytics.com: March 21.
Penn, David . "Rage Of The Machine: The New God Will Fail," LinuxJournal.com: June 27.
Walbert, Laura R. . "The Fools Rushed In . . . Again," Forbes Annual Mutual Fund Survey: August 27.
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