The market hates Lucent (LU) as a growth stock. On Aug. 22, it was the most heavily shorted stock on U.S. stock markets. Even though it now trades at about $7, down from a high near $80 at the end of 1999, many investors obviously expect the stock to fall further.
However, some investors -- and I'm among them, I admit -- clearly like Lucent. In the most recent quarter, according to information on institutional ownership at
on MSN Money, Merrill Lynch Asset Management bought 21 million shares, the Invesco family of mutual funds bought 13 million shares and Fidelity Management & Research bought 6 million shares.
Now, I can't speak for Merrill Lynch or Invesco or Fidelity, but from my own perspective I think I can explain the startling difference of opinion about Lucent -- and some other battered technology stocks.
Growth investors who remember when Lucent traded at $80 a share -- and who owned the stock when it was growing earnings by 50% or better a year -- can't find anything to like about the shares. Value investors, who missed the stock's huge run-up and its crash as well, don't carry that baggage. By their measures, Lucent is now starting to look like a potential buy.
I'm still not ready to pull the trigger, I'll admit, but I've edged over into the value camp in recent days. I certainly wouldn't buy Lucent as a long-term play on the growth of its communications-equipment businesses -- the figures just don't thrill me. But if the numbers Lucent announces for the September quarter are in line with the numbers it projected at the Aug. 23 meeting with Wall Street analysts, I'd say the stock deserves strong consideration for value portfolios. Not all the numbers are clear, I'll grant you, but this stock is shaping up as a very interesting value buy.
I want to be very clear about one thing, however. I'm not interested in buying Lucent because it's relatively cheap. There are many technology stocks that are a lot cheaper than they once were. Most of these are buys now only if you think you can see a strong rebound in technology revenue growth within six months -- and frankly, I don't see enough evidence of that to make me bite at the
of the technology world. I'm interested in Lucent because it's
cheap -- because it has been priced as if the company were going out of business. Lucent is a potential buy at today's $7 a share just because so many growth investors hate this stock.
So why do growth and value investors come to such different conclusions about Lucent?
Eye of the Beholder
Part of it is based on the measures they use to evaluate a stock. Lucent just doesn't stack up very well right now by traditional growth-stock investing standards. On the value investor's scale, however, the stock has hit a sweet spot.
It's easy to see why growth investors would hate Lucent on the numbers. Lucent told analysts that it would take a $7 billion to $9 billion charge against earnings in the fourth quarter of 2001 as it continues to restructure its business. The company expects to lose money in the third and fourth quarters before it reaches profitability sometime in the fiscal year that ends in September 2002. After a tough 2002 for the telecommunications industry as a whole -- Lucent sees industry revenue falling by 5% to 10% that year -- it expects to see growth pick up in 2003. But that growth won't be anywhere near the levels that Lucent or the telecom industry experienced in 1999. Instead, Lucent expects 10% to 12% revenue growth in 2003 and gross margins of 35%.
That's pretty disappointing if you're a growth investor who remembers 1999, when Lucent grew net income by 57% even after you take out all the special gains and charges.
And even if you can forget those disappointing comparisons, the stock just doesn't measure up very well on such standard growth-stock metrics as price-to-earnings to earnings growth rate. If I follow Lucent's math correctly, the company projects earnings of about 37 cents a share in fiscal 2003. At that point, the company would be growing revenue at 10% to 12%. Give Lucent some credit for improving gross margins, which would boost earnings growth to 15%, and then award the stock a very optimistic price-to-earnings multiple on that growth of 30, and the stock price works out to a rather anemic $11 a share. And that's assuming the stock market is willing to pay a multiple of two times the growth rate for the shares. Not much to get growth investors excited about in these numbers.
But the stock looks very different when examined by some of the standard value metrics. If sales have stabilized at something like $20 billion to $21 billion in fiscal 2001 and 2002, as the company suggested, then at $6 a share -- at that price Lucent's market capitalization is about $20.5 billion -- the stock sells for a price-to-sales ratio of just about 1. When a stock falls to a price-to-sales ratio of 1 or less, value investors start to get interested. Forget about growth -- at the current level of sales, to a value investor Lucent seems interesting. The stock is especially intriguing to a value investor who knows that the price-to-sales ratio for the
as a whole is 1.55 -- and that for a group of stocks growing earnings at just 13.5% a year. Certainly, it's reasonable to believe that Lucent might be worth a similar multiple -- for a projected price of about $9.60 a share. And if the company could climb to the 1.84 price-to-sales ratio it claimed in 1995, then the projected price per share equals $11.36.
Same Target, Different Expectations
That's the same potential target price that my growth analysis came up with -- it's also the $11 a share that Morgan Stanley Dean Witter came up with using its own calculations and a standard Wall Street pricing model called discounted-cash flow, for that matter.
I don't cite that agreement because I think it guarantees that $11 a share is somehow the correct future price for shares of Lucent. But I do believe it illustrates an important difference in the psychology of value and growth investors that will be a key factor in the gradual recovery of technology stocks.
Maybe it's best summed up this way: Value and growth investors tend to have very different expectations about risk and reward. Value investors are willing to invest in situations with lower potential returns because they believe they are taking on lower risk. Growth investors tend to demand higher returns because they believe they are taking on more risk.
All the academic evidence I've seen doesn't convince me that one of these schools of investing is innately superior to the other. When practiced intelligently, I think the returns are about the same -- because by and large, value investors and growth investors do have a reasonably accurate view of the risk and rewards in their strategies. A gain from $7 to $11 in Lucent over two or three years is a great return by value standards. On the other hand, I don't think it would impress many growth investors. (One of the interesting things I've noticed about the debate on Lucent is that the growth-oriented analysts who now have "buys" on the stock have much higher price targets than $11 a share. For example, Lehman Brothers' Steven Levy, who recently moved from a bearish position on the stock to a "strong buy," has a price target of $18 a share.)
Both schools of opinion are critical parts of the valuation chain on any stock. Value investors buy early, take less risk and don't demand as much in the way of potential return before investing. Growth investors pick up stocks from value investors, take on more risk and ask to see the potential for higher returns before they put their money on the line.
That suggests that one path -- and it's probably not the only one -- to recovery for a battered technology stock would play out in a sequence like this: First, the former growth stock has to be abandoned by growth investors. Second, it needs to be adopted by value investors, and finally, it needs to be transferred back into the hands of growth investors.
At the time of publication, Jim Jubak didn't own or control shares in any of the equities mentioned in this column.