Sit tight, or sell?
Tech success handcuffs investors
Just about two years ago, most investors were still numb from the TSE 300's 30% crash landing. Then out of nowhere, technology stocks started their meteoric ascent, building wealth faster than the expectations of the most aggressive and optimistic investors. Enter the year 2000, and with it comes the optimism of 1999 and signs of slowing sales and profit growth, which explains the volatility in tech stocks this year. So it's no wonder many investors are a bit nervous and are still wondering what to do with their tech holdings.
Many of the portfolios that I've reviewed lately show huge accrued gains in positions in taxable accounts. So investors face two unattractive options: let the position ride and risk a sectoral decline or lock in those profits by selling and get ready to fork over a pile of dough to the CCRA (Canada Customs and Revenue Agency). Both options are downright ugly but don't lose hope. For those looking to cut exposure to tech stocks, it may be possible without triggering big gains.
The Risk of Sitting Tight
Picture a world class athlete jumping over a hurdle. Raising the level of the hurdle doesn't diminish the athlete's skills, but it does make greater demands of his athletic ability. At some point, the hurdle could be raised so high that it's just impossible for him to successfully clear it. So, the risk I'm talking about with tech stocks is that investors may be paying too high a price in general - exposing many to substantial downside risk. Even though there has been some recent weakness, the future remains very uncertain. The top five stocks in the NASDAQ 100 are household names: Cisco, Intel, Microsoft, Oracle and JDS Uniphase. Even for a great company, there should be a limit to what investors are willing to pay. This NASDAQ quintet is currently trading at an average price of 105 times earnings (P/E ratio of 105), with three of the five having reported negative cash flows over the past year. (The P/E or price-earnings ratio measures the price of a stock per dollar of earnings per share.) Such valuations require huge growth in earnings and cash flows (about 25% annually) over the next ten years just to give shareholders a 10% annualized return. That's a "hurdle" some money managers consider unrealistic, even for industry leaders.
Nortel Networks, the TSE's resident gorilla, has disappointed analysts since December of last year with its earnings reports. Nortel now trades at more than 200 times last year's loss, with its latest reports also showing negative cash flow for the year. Investors in stocks "priced for perfection" may be at risk of severely underperforming their expectations going forward. This is especially true when big traditional firms like Phillip Morris and Ford Motor Company are trading at 8 times earnings (6 times cash flow) and 7 times earnings (1.5 times cash flow), respectively. Many money managers were loading up on value plays like these in the early part of this year.
The Risk of Taking Profits
When you buy a stock, you are only taxed on dividends paid and gains realized from selling shares at a profit. So taking your money off of the table by selling your tech investments would potentially trigger a huge tax bill. One case I reviewed this week holds the Universal World Science and Technology fund in a taxable account. Originally, $23,000 was invested back when the fund was introduced (1996). Now, it's worth over $90,000. Selling that entire holding would trigger a tax bill of over $20,000 (a taxable gain of nearly $45,000). That's also a huge risk since you are making a large prepayment of taxes when you could defer longer. But of course selling would lock in profits in the event that tech stocks lose their sizzle. So what are investors to do? Here are a couple of tips that may help.
One way to avoid a big tax bill and still reduce risk is to structure your RRSP in a manner that nicely offsets your tech holdings. For instance, holdings in bonds, real estate, financials, and energy have historically had low correlations with technology. The most conservative way to go if you still want equity exposure is to find a good dividend fund like AGF Dividend, Standard Life Dividend, PH&N Dividend, or Maxxum Dividend. All hold relatively larger cap stocks and typically have a healthy portion in higher yielding bank stocks.
Capital Loss Matching
Wherever possible, match up accrued gains and losses (if any) on your taxable holdings to see if that gives you more flexibility. For instance, in the case mentioned above, one tech holding bought recently was down about $11,000, while another tech holding was up by about the same amount. So I was able to get rid of both without any tax consequences. Other items to check before making any decisions are things like capital loss carryforwards and allowable business investment losses. Both could reduce gains from selling securities.
Sell Pure Plays First
If you're a mutual fund investor, you most likely picked up your tech exposure from a few different funds. In that case, tech exposure can be reduced by first selling those funds that are mandated to invest in technology (pure plays). That would leave funds like Spectrum American Growth, 20/20 Aggressive Growth, and AIM Global Theme Class. At the peak, all of these funds had huge positions in pricey tech stocks. However, all of these funds (and many others) reduced those positions during the first six months of this year. Though they continue to hold a substantial 40% to 50% in tech stocks, the focus has shifted to higher quality issues. Pure plays don't have the same level of flexibility.
If neither of these options is sufficient to make a dent in your technology exposure, then you'll have to decide for yourself which risk is greater. But my experience has been that some combination of the above strategies should result in reduced tech exposure without prohibitive costs.
This article is not intended to provide advice on, or promote, the investment merit of any individual equity securities. Before taking any action, investors should consult a qualified professional.
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 email@example.com All stock price and valuation data is as of the close of business September 14, 2000.
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