Should the long-term, buy-and-hold investor be snapping up technology stocks now?
I think the answer to that is no. Not yet. The potential risk still outweighs the potential reward for the buy-and-hold investor.
That's not an easy call. And I fully expect to be buried under piles of outraged emails that point out how cheap some great technology names are now, and how strongly these stocks have moved up in the recent rally.
So let me be clear: I think a strong case can be made for trading technology stocks in the short term -- buying on current momentum, selling on future valuation ceilings. But that very case is what convinces me that now is the wrong time to be a buy-and-hold tech investor.
Group A and Group B Tech Stocks
As always, I think you're entitled to see my reasoning. Reading the strongest argument possible for a particular position is one of the best routes to reaching your own conclusions -- whether you end up agreeing or disagreeing with the argument.
Let me begin with a Group A/Group B analysis that I used in my column on bank stocks for the buy-and-hold investor. (See my column on
how to tell a smart bank from a dumb one.)
Group A comprises the punished and the cheap. This group is especially attractive to long-term investors because it contains familiar stocks that were star performers during the last bull market. These stocks are now trading at small fractions of their former prices. Bank stocks in Group A include
J.P. Morgan Chase
. The list of technology-sector members of Group A is much longer:
. These five stocks are down 35%, 28%, 30%, 77% and 47%, respectively, so far in 2002.
Group B comprises stocks that have risen or held steady as their same-sector peers plunged. The companies in Group B typically have taken market share from rivals or exploited new expansion opportunities. In the technology sphere, this group includes
, up 11% year to date,
, up 6%,
, up 16%, and
, up 18%.
Growth at a Hefty Price
So how do these two groups of technology stocks shape up as buy-and-hold candidates? Let's start with Group B.
Unlike in the banking sector -- where solid new growth opportunities support higher (but not astronomical) price-to-earnings multiples -- investors have bid up tech shares substantially compared with their real-world prospects. It looks like every technology investor who has kept money in the sector during the bear market has opted to own one of the few solid performers from Group B. That means anyone looking for growth can expect a very hefty price tag.
Consider Electronic Arts, whose earnings are expected to grow by 25% a year over the next five years, thanks to the company's domination of the electronic-game industry. Electronic Arts shows a current price-to-earnings ratio of 62. Symantec, which should benefit from the need to keep computers safe from hackers and viruses, trades at a current price-to-earnings ratio of 54; that's very rich for a company projected to grow 17% a year over the next five years. None of the stocks in Group B shows a PEG ratio (P/E-to-earnings-growth-rate ratio) of less than 2.5. If you want to buy long-term growth, these technology stocks are simply a much more expensive way to go than the bank stocks I looked at on Oct. 22.
Growth at a Reasonable Price
Then there's Group A. The technology-stock story here is more complicated, but the final picture isn't substantially different.
First, as I did with banks, you need to divide the Group A companies into: 1) those that have strengthened their competitive positions during the bear market, and 2) those whose positions have eroded or will erode soon.
While your view may differ, here's where I draw the lines: Improved competitive position -- Cisco Systems, Applied Materials and Nokia. (It's hard to imagine, for example, that Cisco is going to find it tougher to sell against the bankruptcy-threatened
now than in it did in 2000.)
Potentially weakened competitive positions: Sun Microsystems and Intel. In Sun's case, Dell continues to eat away at the server market from the bottom, keeping the pressure on pricing. In Intel's case, there's the real possibility that Advanced Micro Devices' Hammer chip will completely upstage Intel's competing 64-bit processor and do real damage to the top end of Intel's product line. Is the damage likely to prove fatal in the case of either Sun or Intel? No, but both companies face a period of turmoil until it's clear exactly how strong the competition will be.
A buy-and-hold investor looking for growth at a reasonable price (and with as little risk as possible) is going to rule out stocks like Sun, seeking instead members of the group that includes Cisco.
Is Cisco Cheap?
Now, if all you do is look at the projected near-term earnings growth rate for Cisco, the stock looks reasonably cheap. Analysts expect earnings per share to grow at almost 44% for the fiscal year ending in July 2003. With Cisco currently trading at a P/E of just 47, that growth looks cheap, no?
Cisco is a stock coming off an earnings bottom -- and the low earnings of that bottom results in an unsustainably high growth rate immediately after the stock turns a corner. But investors can't extrapolate a huge jump in growth off the bottom into a long-term rate of growth. Wall Street analysts now project that Cisco's annual earnings growth over the next five years will average 18%. Using that consensus estimate, Cisco has a PEG ratio of 2.6 instead of 1.1.
But even that doesn't capture all the complexities of the situation. Look what happens if the current rally, which has lifted Cisco and other big-cap tech stocks off their bottoms, continues for a while. Let's say Cisco rallies from its close of $11.78 on Oct. 25 to $17 a share, its May high.
At $17 a share, the stock's price-to-earnings multiple would climb to 68 and the PEG ratio on the five-year annual projected growth rate would climb to 3.7. Looking at just those numbers, most investors would decide to sell rather than hold for the long run -- and I think they'd be right.
The case for selling after the stock rallies to $17 gets only stronger if you consider the risk in these earnings estimates. Given the cautious nature of Cisco's recent guidance, it's unlikely the company will endorse a five-year growth rate during its next earnings report Nov. 6. The troubles at Lucent and Nortel may be good for Cisco in the long run, but, in the short run, their struggle to produce revenue keeps pressure on prices. And nobody at any of these companies has been willing to predict when telecommunications companies will start buying equipment again. That projected 18% long-term earnings growth rate is, let's be frank, a guess. The actual growth rate could well be 15% or 10% or even 8%, as some Cisco bears have suggested.
With that risk as context, selling at $17 seems even wiser. And long-term investing in Cisco seems less attractive.
Small, Mid-Caps Also Risky
Switching from large-cap stocks to smaller companies doesn't make the numbers look much better. For example,
RF Micro Devices
, a company I owned in Jubak's Picks before the bubble burst, has been doing just about everything right: cutting costs, gaining market share and expanding into new product lines such as wireless local area networks. The company has, in fact, been so good at running its business that it recently raised sales guidance for the December quarter. Investors can expect 5% more growth than the 7% to 10% the company had estimated earlier.
So it's not especially surprising that the stock has climbed 23% in the past month.
But that puts the buy-and-hold investor looking at RF Micro Devices in the same box as the potential Cisco buyer. At the Oct. 25 closing price of $7.71, the stock trades at 59 times projected earnings per share for the fiscal year ending in March 2003, and 35 times earnings per share for fiscal 2004. Projected growth rates are 73% for fiscal 2004 -- again, off the bottom -- and 26% on average for the next five years.
And of course, none of these growth projections are guaranteed. Some Wall Street analysts looking at projections of wireless phone demand for this year from RF Micro Devices' two biggest customers, Nokia and
, have started to see signs of a potential inventory buildup of phones at the end of the year. That would put the earnings estimates for RF Micro Devices for 2003 in jeopardy.
All in all, the stock looks like a more profitable short-term trade to be sold into the year-end rally than a long-term, buy-and-hold investment. (In the interest of full disclosure, I own a position in RF Micro Devices that I bought before the current rally, and I will probably sell it into this rally at some point with the idea of repurchasing after either the price goes back down, or the end-of-year inventory worries are proved groundless.)
In my efforts to find something to recommend as a buy-and-hold stock in the technology sector, I've found a number of small- and mid-cap stocks that are attractive as short-term trades; I would consider these as buy-and-hold candidates only at lower prices or at a time of less market and economy risk. The list, for those who want to do further research, includes
I think there are some good trading ideas there -- not without risk, because the duration of the current rally is uncertain -- but nothing that's a great buy-and-hold candidate. The technology sector just doesn't seem to be ready yet.
At the time of publication, Jim Jubak owned or controlled shares in none of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.