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SPOOKED BY TECH STOCKS?
Tech rebound won't be quick

It seems that the bad news just doesn't stop when it comes to the technology sector these days. This is in sharp contrast to where we were a year ago, with the NASDAQ 100 trading at nearly 4,600 - more than 112 per cent higher than the March 29, 2001 closing price. While tech stocks rose to their glory on momentum and optimism, today's tech stock investments are being severely punished for the lack of momentum in revenues and profits. It's time to revisit the question that I've been hearing so much of during the past several months - "should I sell my tech holdings, buy more, or just hang on to what I've got?"

TECH STOCK PRICE DRIVERS

Recall that future returns from stocks are largely driven by the following factors:

  • industry fundamentals;
  • interest rates; and
  • current stock prices (and other company fundamentals).

    Read the newspaper on any given day and you're likely to see that the technology industry remains fragile. Fat inventories and continued slowing in tech spending means that the current surplus of tech equipment will take awhile to work its way through the economy. Then, as inventories slim down, demand must persist in order for growth in revenues and profits (if any) to regain strength.

    As we've discussed previously, it's unlikely that interest rates will rise. So far this year, US interest rates have fallen substantially. While that's not a guarantee of good returns, it is a positive sign for the future of stock prices.

    Morningstar.com shows a beefy price-earnings (P/E) ratio of more than 47 times, but it's important to look a little deeper into that figure. Most published P/E calculations exclude companies with negative ratios (and that' s the case elsewhere within morningstar.com). Nearly 30 per cent of the NASDAQ 100's top twenty-five stocks have negative P/E figures because their earnings are negative. When Montana-based investment researcher and money manager InvesTech examined all 4,800 stocks trading on the NASDAQ, they found that the true composite P/E ratio was 94 as recent as two weeks ago. In fact, InvesTech found that the NASDAQ's 4,800 stocks, at their peak, had a P/E ratio of about 245 times.

    Those are frightening figures when compared against the financial performance that the constituent companies must deliver in order to provide shareholders with a decent return. To provide a 10 per cent annualized return over a ten-year period, NASDAQ's 4,800 companies would need to growth their profits by more than 23 per cent annually over ten years - an enormous figure, particularly when put in the context of today's economy. Even if we take the P/E ratio of 47, profit growth must still exceed 15 per cent annually to give investors an annualized return of 10 per cent over a ten-year period. It can be argued that some of the companies in the NASDAQ could generate that type of internal growth, but it's quite a tall feat for 4,800 of them to do so. Though current valuations are quite important, let's not get hung up on P/E ratios. Other market activities point to desperation for some big players.

    THE IPO MARKET

    Lucent Technologies spun off its optic components subsidiary, Agere Systems Inc., in the midst of horrible conditions this week. The only sensible reason for going ahead with the planned initial public offering (IPO) is that they needed the money badly to reduce their huge debt load. This is just speculation but consider the following facts.

    Prior to actual trading, the price of the Agere IPO was cut three times from the US$15 to US$20 range down to US$6. The end result: Lucent received just US$3.6 billion in proceeds - just over half of their initial expectations. It's no secret that the market's infatuation with tech stocks (including fibre optic stocks) is a faint memory. Also, Nortel Networks has been planning a very similar spin off but has continued to delay it since they felt they wouldn't get the subsidiaries true value from such a bad market environment. Even non-technology companies, such as mutual fund firm Altamira, have delayed planned IPOs due to the general market unrest. However, Nortel isn't the only tech firm delaying an IPO.

    Looking to the venture capital level of the market, IPO activity in the tech industry hit a brick wall. Venture capital backed IPOs are essentially small private companies that are preparing to trade in the public markets for the first time. In a survey of US venture capital funds, technology IPOs dropped 83 per cent during the final quarter of 2000, compared to the same period in 1999 (source: PricewaterhouseCoopers MoneyTree Survey in partnership with VentureOne), capping the third consecutive quarter of declining IPO activity.

    If Lucent thought the market would turn around relatively soon, it's reasonable to conclude that they would have delayed their IPO until more a favourable sentiment had returned to the market. The odd timing of the Agere IPO may be indicative of Lucent's own sentiment at the moment.

    SUMMARY

    My December 22, 2000 article was the last time I gave an opinion on tech stocks. In a nutshell, I said that significant risk remained in the group and that buyers (that is if you're buying at all) should be cautious by avoiding lump sum purchases. I'd say my sentiment hasn't really changed since stocks remain quite expensive in a market environment that remains unfavourable. That said, here are a couple of suggestions for those currently holding tech investments.

    If you're holding tech mutual funds or stocks, sitting tight might be your best bet. While more downside risk remains in the short-term, there is less risk now than there was a few months ago. You may want to contemplate selling if technology still comprises a disproportionate amount of your total portfolio. For balanced portfolios (a mix of stocks and bonds), technology should account for a maximum of 10 to 15 per cent of your total portfolio. For aggressive investors, that maximum could be raised to 20 or 25 per cent at most. Finally, always make sure to look beyond your tech-specific funds. Many "diversified" foreign and domestic stock funds hold some technology, particularly if using a growth-oriented investment style. That can help you gauge your portfolio's total technology exposure and take the course action that's right for you.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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