Tech Stocks' Date with Reality


For a few years in the late '90s it was a gospel truth among investors that technology stocks would always increase in value faster than any other sector. Even after the Internet bubble burst in 2000, followed by a painful three-year bear market, some of the most hallowed tech bellwethers -- names like Cisco (CSCO), Microsoft (MSFT), Dell (DELL), Intel (INTC) -- commanded premium valuations. Investors held them all the way down -- and when the stock market began to recover, they started buying more in hopes of seeing their eventual return to earlier highs.

Most of those tech bellwethers are still far below those lofty levels. Yet, on a valuation basis, they remain more expensive than stock market averages. According to data from Standard & Poor's, the price-earnings ratio of the information-technology group is 22, vs. 17 for the rest of the S&P 500-stock index. Microsoft's 2004 p-e was 36, Dell's 33, and Cisco's 20. This disparity persists even though IT stocks gained just 1.8% in 2004, vs. 9% for the S&P 500.

Why the big difference? "The former tech bellwethers have a very loyal core following of investors that adhere to a buy-and-hold strategy and expect to see their patience rewarded at some point," says Joseph Battipaglia, chief investment officer at Ryan Beck & Co., who adds: "They could be waiting a long time."

"HARD TO SWALLOW." This may be the year that tech stocks finally get in line with valuations in other sectors -- and that would be a painful process for tech loyalists. Earnings growth rates for tech stocks have already fallen in sync with the rest of the market. For the fourth quarter of 2004, earnings of tech stocks in the S&P 500 are projected to grow 15.4%, the slowest rate since the second quarter of 2002 and only slightly higher than 15% rate for the S&P 500 overall, according to Thomson First Call.

In 2005, tech earnings are expected to climb 13%, only a bit better than the 10.5% for the S&P 500, according to First Call. This narrow difference is in stark contrast to 2004 when, thanks to a surge in earnings over the year's first three quarters, tech stocks grew 43%, vs. 20% for the S&P 500.

While a handful of tech stocks may really deserve high multiples, "to think that these sorts of multiples are justified for a whole bunch of them is pretty hard to swallow," says Curt Morrison, a stock analyst at Morningstar.

BUYING OPPORTUNITY? But with so few names showing stellar growth, tech titans such as Google (GOOG), Apple (AAPL), and Autodesk (ADSK) are also overpriced, many analysts believe. "Money has crowded into the few attractive houses that can be found in the still tough neighborhood of technology investing," writes Arnie Berman, tech strategist with research firm CreditSights, in a Dec. 20 report.

Tech investors may already be waking up to the fact that they're paying too much. In 2005's first week of trading, tech stocks fell 6%, vs. a 2% drop in the S&P 500, according to Merrill Lynch's TechStrat Team. "Is this weakness a buying opportunity?" the analysts asked in a Jan. 7 report. "We don't think so," they answered.

Analysts at Merrill and other Wall Street firms are worried about weakening earnings growth, softening consumer spending, and business spending that's improving only slowly. A recent Merrill survey of chief investment officers found that IT spending would increase by 3.9% in 2005, down from 6.3% in 2004.

SELECTIVE SPENDING. Government reports reflect the slowdown in tech spending as well. The Commerce Dept. reported on Jan. 4 that durable-goods orders for computers and electronics fell 5.7% in November. The minutes of the Federal Reserve meeting on Dec. 14 also included some hand-wringing over a "possible downshift in the pace of high-tech spending."

Why are businesses pinching pennies in the midst of an economic recovery? "Companies are spending money on tech, but only tech that will cut their costs," says Peter Cohan, a management consultant and author in Marlborough, Mass. By way of illustration, he cites projects to improve human-resources software systems already installed and the replacement of proprietary servers and software with cheaper, open-source Linux systems.

"These are things that don't require large investments," says Cohan. "Companies are still trying to get the return on investment that they were promised seven or eight years ago."

FEW CHOICES. An additional reason why tech-stock valuations could come under pressure in 2005: Tech companies may suffer big hits to their reported earnings as a result of new requirement to expense stock options, starting in the middle of 2005. The tech industry has used stock options as compensation more aggressively than other, and it may decide to cut back the amount of options being offered.

If they don't cut back, earnings would take a major hit. Joe Abbott, senior equity strategist at Oak Associates, figures earnings for tech companies in the S&P 500 would have been 25% lower in 2004 if those outfits had been required to expense options. That would make tech stocks look even more expensive on a p-e basis than they do already.

Tech investors are left with a few choices: They can hope for earnings surprises that would justify those outsize valuations, or they can decide that the buy-and-hold strategy no longer makes sense. Battipaglia recommends investors buy tech when they find companies that are inexpensive, either because they're in the middle of a possible turnaround -- Hewlett-Packard (HPQ), for example -- or at the bottom of a cycle, where Intel can be found every few years (although not at the moment).

When will the tech stars fall back to earth? "It's hard to tell if this is the year," says Morrison, "but I think the chance of tech valuations coming down in the next two years is substantial." Judging how 2005 is going so far, this just may be the year. By Amey Stone in New York


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