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Is technology a buy?
Volatile sector has room to fall yet

Three weeks ago, I wrote of the extreme valuations in technology stocks. Since that article was published in this space, the tech-heavy NASDAQ index has stumbled to the tune of more than 17 percent. I'm not pointing this out to pat myself on the back but because many analysts are screaming "buy" on this volatile sector. In fact, many analysts are split as to whether the stock market's fallen angels are now back into bargain territory. Here's my case for why prices are still too high, overall.

Recent Decline

The NASDAQ's recent decline was lead by the "big five" that comprise 25 percent of this index. Microsoft, Cisco, Oracle, Intel, and JDS Uniphase have dropped an average of 22 percent since September 15. However, valuations are still astronomical in the sector. For example, the NASDAQ's "big five" still trade at an average price of 151 times their last year of reported cash flows and 62 times last year's profits. (Stock prices are often quoted in relation to the company's profits and cash flows to compare firms of varying sizes.) This group of stocks has seen profit grow by an average of 39 percent over the past five years and analysts are expecting growth to continue at a 30 percent annual rate over the next five years. Two key questions must be answered before you act with your dollars. First, are those expectations reasonable? Second, what's needed to provide you with a good return?

Great Expectations

Remember that stock prices always reflect the market's consensus of what the future holds. While recent sell-off activity (due to negative earnings surprises) indicates a bearish attitude going forward, today's prices still hold a rosy view of the future. What is a reasonable rate of return? Most stock investors have grown accustomed to 10 percent annual returns, but my experience is that investors in technology tend to expect more like 15 percent. (Personally, I think those expectations are too optimistic over next five to ten years, but let's go with those numbers for a moment.)

Suppose you buy a stock, paying a price equal to 151 times that company's cash flows, and hope to get a return of 10 percent annually over the next five to ten years. What is needed to make that happen? The company would have to grow its cash flows by 46 percent in each of the next five years just to give you the desired 10 percent return. If 15 percent is your target, those cash flows must soar by nearly 64 percent in each of the next five years. (Both cases assume the growth rate gradually falls subsequent to the fifth year.) Our focus here is only cash flows because they're more reliable and more stable (less variation than earnings).

A 30 percent growth in profit usually doesn't result in equal growth of cash flows. Further, academic research has shown that companies that can sustain high growth rates over long periods of time are rare beasts. That same research suggests that growing cash flows (or profits for that matter) by 40 percent or higher rates for extended periods isn't likely to sustained for long periods, especially after a period of already high growth. The exceptions of course are companies that have a monopoly, long-term patents, or some other unusual advantage over its competitors. Could I be wrong? Of course, but I'd be willing to bet that, at current levels, there remains more downside risk than upside potential in the tech sector over the next five years.

The higher the purchase price, the greater the probability of negative surprises. Does that mean go out and buy the cheapest stocks? Not necessarily, but it does mean investors should pay closer attention to what they buy and how much they pay. The fact that kids love video games doesn't automatically make video and computer game manufacturers "sure things" by any measure.

Cautious Tech Plays

It's pretty clear that I'm no exactly moved by the "bargains" in the technology sector these days. That said, some opportunities have emerged as many stocks that were once very expensive have dropped like stones to valuation levels that are much more reasonable (under 30 times profits). If after weeks of me harping about valuations you still want exposure to this sector, I'd advise doing so with a more conservative play.

Mackenzie Financial's Universal Future fund is probably the single best way to invest in the tech sector right now, with its technology core and many risk controls. Risk is controlled in four ways. This fund is not a pure tech fund. It holds about 50 to 60 percent in technology, about 20 percent in energy stocks, with the rest in cash and a diversified group of picks. The energy component nicely offsets the tech component to smooth out returns over time. Lead manager John Rohr also has a broad definition of technology, which gives him more flexibility to buy stocks that are leveraging technology to grow their business even if the technology itself isn't its core product. He generally limits any one stock to 6 percent of his total portfolio - though he made a rare exception with JDS Uniphase (a good move). Finally, Rohr is more sensitive to high prices, as compared to other tech fund managers. JDS Uniphase rose to nearly 8 percent of this fund's assets before Rohr began trimming it down to 4 percent. Profits on other pricey tech holding were also taken but the cash wasn't reinvested. Rather, it piled up in the fund's cash component (up to 20%) long before this decline arrived. Add in a low turnover rate of about 20% annually (i.e. average holding period of 5 years) and you've got a fund that is about as conservative as it gets when it comes to high tech holdings.

My concerns about valuations aren't centred upon any one stock but rather on groups of stocks - technology issues. If you hold any individual stocks, most of my comments may not apply to your situation. However, I hope it will prompt all of you to take a second look at what you're holding so that you can judge its appropriateness for your portfolio.

Disclaimer

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 dha@danhallett.com All stock price and valuation data is as of the close of business October 11, 2000.
 
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