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Yin and Yang Stocks


Tech stocks are back. So, too, is the problem that frustrated so many investors during the late 1990s boom: how to size them up. The first hurdle is the cost because, once again, tech stocks are hugely expensive by the usual measures. Those in the Standard & Poor's 500-stock index are priced at 33 times their estimated 2003 earnings, a 79% premium to the index as a whole. Shares of Internet leaders Amazon.com and Yahoo! (YHOO) Inc. are off the radar at 70 and 87 times expected earnings, respectively.

What's a tech investor to do? Start by dividing stocks into two categories: those for trading and those for investing. With trading stocks, you make money by figuring out whether other traders will keep buying or start selling the stock and positioning yourself accordingly for a few weeks or even days. By contrast, with investing stocks you aim to buy into a company at an attractive price, given the worth of its assets and likely future profits, regardless of when the value will be recognized by the market. This way, you can steer clear of overpaying for fashionable dogs.

There's nothing revolutionary about this strategy, of course. It's just a question of calmly mixing and matching some old, and apparently somewhat contradictory, stock market wisdom and applying it to a hot market. About 70 years ago, British economist John Maynard Keynes, who earned stock market fortunes for his Cambridge college and a London-based insurance company, said investors should view the market as a beauty contest, and they should mainly buy trading stocks that other people would find attractive.

American hero Benjamin Graham, the father of modern securities analysis, bristled at that idea. He lamented that stock buyers, though almost always called investors, are often actually speculators. Instead, he preached that they should make a hard-nosed assessment of the inherent value of companies and search out investing stocks.

At the height of the NASDAQ market boom of early 2000, the very idea that any tech stock could still be an investing, or value, stock was implausible. Aside from the much-hyped Internet stocks, shares of such solid companies as Microsoft Corp. and Intel Corp. soared as if growth in the companies were boundless. But much of the speculative fever that drove the big names way up cooled way off, and the stocks deflated as their businesses suffered an inevitable cyclical downturn. Now, these companies are settling into a comfortable maturity with dominant franchises and relatively predictable earnings that can be sized up for investment.

Forget eyeballs, first-mover advantage, and the other fanciful metrics that the dot-coms used to toss around. Investing stocks tend to have lower price-earnings ratios than high-flying Internet stocks, balance-sheet strength, and the resources to pay dividends, if they wish. What's more, they seem able to keep earning money throughout the economic cycle, and they spin off cash, lots of it. Their baseline business through the cycle yields data that can be analyzed to reach reasonable estimates of what they are worth.

For investors scorched by cash-burn in the bubble days, when telecom and Internet companies and some other techs frittered their funds with all the abandon of a sophomore on spring break, the positive cash flow that the investing stocks throw off is especially appealing. Microsoft alone has piled up $49 billion of the stuff, equivalent to about $4.50 per share. "Cash doesn't lie," says Kevin Landis, portfolio manager at San Jose (Calif.)-based Firsthand Funds.

Truth to tell, there are some dependable companies whose relatively low p-e ratios make them good candidates for investing stocks. For example, Affiliated Computer Services (ACS) Inc. offers investors a chance to participate in nearly 20% earnings growth from demand by corporations and governments for outsourced IT. ACS shares are priced at a modest 19 times earnings, and most of the company's revenue is dependable because it's largely based on contracts that are renewed regularly.

IBM, the granddaddy of them all, has a p-e of around 19 and pays a dividend. It currently yields 0.8%, but that has been growing at a smart 7.5% annual clip. Now, Microsoft, with a p-e of 25, is starting to pay dividends. PC maker Dell Inc. has many of the characteristics of an investing stock: a strong franchise and savvy marketing that produce 15% annual earnings growth and 40% returns on capital. Although it pays no dividend, it isn't lumbered with any debt. But lately Dell's p-e has ratcheted up to around 33, diminishing some of the stock's investing appeal. Even Intel, with a PC-microprocessor franchise so strong that it spun off profits even during the tech bust, is starting to look like a trading stock.

In fact, after the dizzy 24% runup in the S&P 500 Info Tech index since Mar. 31, more and more shares are moving into the trading category. Their price action alone is the big draw to one group -- the momentum traders. They don't care a fig about the fundamentals of a company's business. They may not even know what it does. Their philosophy is simple: What goes up is going to go up some more.

They have a point. Mutual- and pension-fund managers are judged according to a benchmark index and, if one stock or a group of stocks in it is shooting up, they can't afford to be left behind. They all pile in, creating a bandwagon effect. Consider Applied Materials (AMAT) Inc., which has one of the largest market caps in the S&P 500 IT index. The stock has run up 57% since Mar. 31, to $19.77, even as analysts have trimmed their earnings estimates from 49 cents a share to 46 cents for the fiscal year through October, 2004, according to Thomson First Call.

Why do momentum traders have such clout? Simple. They control at least one-third of the money invested in tech stocks, says Walter C. Price Jr., veteran manager of the Pimco RCM Global Technology Fund. And if they can power sharp and fast runups in prices, their impact can be equally vertiginous if they fall out of love with a shooting-star stock. During the past 12 months, one-third of tech stocks suffered single-day drops of at least 20%, according to UBS Research (UBS) One of them, Nokia (NOK) Corp., plunged 20% on July 17 after execs said the fall in the U.S. dollar would halt revenue growth from mobile-phone sales in this year's third quarter.

Another big group of traders looks for movement of another kind -- in earnings. They focus on companies they think are likely to beat the market's expectations. A positive earnings surprise can produce a real pop. For example, eBay Inc., whose stock has been one of the star performers in the past year, has beaten earnings estimates by 2 cents to 5 cents a share in each of the past four quarters. The same can happen when Wall Street's much-maligned analysts raise their estimates of company earnings.

A classic example is SanDisk (SNDK) Corp., a leading supplier of flash memory for digital cameras. The stock shot up 246%, to $58.32, from Mar. 31 through Aug. 4 as estimates for this year's earnings more than doubled from 84 cents a share to $1.87. Estimates are soaring because the flash memory that the company makes is in short supply as demand for digital cameras climbs. The problem for the stock, says Price, is that the profit windfall to the company won't last when competition moves in and demand growth slows. "Everyone who owns that stock knows they will have to sell, whether today or six months from now," he says.

As anyone who went along for the wild late '90s ride in stocks knows, traders can't resist a good story. The merest hint that a company has a dazzling product is often enough to set its stock alight. Shares of wireless-chip supplier Unova (UNA) Inc., for example, rose 10%, to $11, on June 26 after MSN.com reported on the potential of its RFID, or radio frequency identification, tags, which track retail products. Since these smart tags are in their infancy and the company is losing money, the story and the hope that it might one day become a big money-spinner powered it higher.

Still, the frontier between trading stocks and investing stocks isn't fenced off. Stocks can cross and re-cross the border with regularity. Intel shares are up more than 54% since March, driven initially by attractive fundamentals. But lately, the momentum crowd has jumped aboard for the ride. Meantime, other traders are attracted by the prospects of upward revisions of earnings estimates as the economy improves. In fact, earnings revisions and stock-price momentum are historically highly effective predictors of stock returns a year later, according to Vadim Zlotnikov, chief investment strategist at Sanford C. Bernstein & Co.

Sometimes, when companies have high potential earnings growth, it can be difficult to tell whether the stocks are moving on trading momentum or on real market insight into their potential future value. Consider eBay. Consensus Wall Street forecasts figure its earnings will grow from $1 a share in 2002 to $1.50 in 2003 and $2.09 next year, according to Thomson. But even if those estimates prove right, buyers of the stock are still taking a speculative plunge. With the shares at $103 recently, they were trading at 49 times the 2004 estimates, a 49% premium to the current p-e for stocks in the S&P IT index.

Clearly, investors sometimes need to think like traders. Pip Coburn, global tech-stock strategist at UBS Research, says they should consider what he calls tactical speculation. This means buying stocks of solid companies, such as Intel or Cisco Systems Inc., whose sales are fairly sure to advance as the economy recovers, giving them a good chance of pleasing traders with earnings surprises in the future. The tricky part is getting out before the smart traders start to dump the stock because they think it may soon run out of steam.

Nobody said it would ever be easy to make money in tech stocks. But life can be a lot less nerve-racking after you work out how much risk you're willing to assume -- and whether that makes you an investor or a trader. Once you've decided who you are, it's best to stick to your role. A split personality will only make it that much harder to distinguish the risks from the opportunities in the market. By David Henry


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