There’s just about no limit to the earnings, sales and productivity gains technology companies can generate.
Tech companies aren’t subject to ordinary economic forces, such as interest rates.
A tech company’s prospects are more important than its earnings.
These were some of the guiding principles that millions of investors embraced as they created the historic surge in tech stocks that started in late 1998. The hottest stocks were pioneers of the young Internet, and they were among the highfliers buoyed by a widespread faith that a new set of rules applied to tech stocks.
“It’s Not Tulip Mania,” declared a report by Merrill Lynch & Co.’s chief economist, Bruce Steinberg, that attempted to justify the stratospheric gains of big tech companies. The report was published March 13, just after the Nasdaq Composite Index had hit a peak of 5048.62.
What’s clear now, in light of the decline in the Dow Jones industrial average and the Nasdaq Composite Index, is that many of investors’ most cherished beliefs about technology stocks have come unraveled. We’ll take a look at six of the most potent myths — three today and three tomorrow — and the difficult truths that, in hindsight, they were masking.
– Myth No. 1: Tech companies can generate breathtaking gains in earnings, sales and productivity for years to come.
This was probably the most pervasive and influential of all tech-stock myths, partly because it seemed so hard to challenge. Growth in tech-company sales and earnings was undeniably outpacing growth elsewhere. This discrepancy was widely believed to make big New Economy companies different from big Old Economy companies, most of which typically achieve single percentage-point increases in annual sales.
In February, Jeffrey Warantz and John Manley of Citigroup Inc.’s Salomon Smith Barney unit published a report claiming that the huge gains in tech-stock prices were reasonable because “the growth in projected earnings has been equally impressive.”
Technology’s contribution to economic growth underpinned the analysis by Merrill’s Steinberg in his Tulip report. In the late 1980s, he noted, earnings at big tech companies grew more slowly than at most other companies. By the late 1990s, tech earnings were growing twice as fast as those of other companies, which was a good reason to value tech stocks more highly.
The facts weren’t wrong. But this view didn’t take into account that the price of tech stocks had grown so fast that the stocks had become “priced for perfection,” as the skeptics like to put it. Any false step and the stocks would plummet. Nor did this perspective on the market take into account a historic reality: No matter how good a company is, it can’t maintain as a large organization the same growth rate it had when it was much smaller.
Dell, for example, boosted revenue by about 50 percent a year from 1996 through 1998. Skeptics said that a company selling a commodity like a personal computer just couldn’t keep posting those kinds of gains year after year. Dell enthusiasts, whose numbers grew as the astounding results rolled in, maintained that its direct-sales model and use of the Internet would permit it to surprise skeptics for years to come.
Then, in 1999, sales growth slowed to 38 percent — still enormous, the bulls enthused. But earnings growth also slowed, and in the fall of 1999, Dell warned investors that its earnings would fall short of estimates. The stock bounced around as bulls and bears fought it out over the company’s growth prospects. But in the end, the skeptics were proved right.
– Myth No. 2: Tech companies aren’t subject to ordinary economic forces, such as a slower economy or rising interest rates.
Until the late 1990s, technology was considered a cyclical business, its sales and profits rising and falling with the overall economy. But as the tech craze shifted into high gear, one of the most popular arguments in favor of technology companies was that demand for their products was so enormous that it would keep growing through the peaks and troughs of the Old Economy.
Demand has remained strong, but not as strong as many more optimistic investors had hoped. Personal-computer sales, for example, were thought to be able to grow regardless of general economic conditions, as they had through most of the 1990s, says Andrew Neff, an analyst at Bear Stearns Cos. As recently as early August, he told clients to expect a strong second half for PC sales, “driven by multiple factors,” including the end of Y2K hangover, Microsoft’s Windows 2000, a turn-up in Europe and the launch of Intel’s Pentium 4 chip.
But then one PC-related company after another shocked investors with warnings of softening business, from Intel to Dell to Apple Computer. Neff, who used to dismiss such warnings as “company specific,” now says he has changed his thinking. “Demand problems are serious and difficult to quantify,” he says. The PC business is now cyclical, he adds, and investors should sell PC stocks when the fundamentals begin to deteriorate.
In the same vein, rising interest rates were once thought bad for tech companies because they slowed the economy and made it costlier for customers to finance purchases. But as the Fed began raising rates last year and tech stocks, after a brief dip, kept rising, many analysts argued tech companies were immune to interest rates because demand for their products was so strong and their borrowing needs so slight.
As it turns out, even though tech companies don’t borrow much themselves, their customers do. And as buyers have curtailed spending, tech suppliers have suffered.
– Myth No. 3: Monopolies create unbeatable advantages.
Some tech companies were thought to deserve extraordinary valuations because the nature of their products created near monopolies.
The huge number of people using Microsoft’s operating-system software or America Online Inc.’s instant-messaging service gave those companies a critical mass of customers — a network — that made it hard for others to break in and compete.
“Networks offer the opportunity for explosive shareholder returns,” Michael Mauboussin, Credit Suisse First Boston Corp.’s chief investment strategist, wrote in May.
One problem with this argument is that government may become suspicious of monopoly power. The Justice Department’s antitrust suit against Microsoft has helped cut its stock in half and reduce its market value to about $285 billion. Now, authorities are raising questions about AOL’s instant-messaging service. WorldCom Inc., the dominant carrier of Internet traffic, has seen its stock hammered since a proposed merger with Sprint Corp. was derailed by antitrust concerns.
Moreover, monopolies may erode as the marketplace evolves. Beyond the government antitrust suit, Microsoft faces the far more daunting danger that its customers will reject the desktop computer as online and wireless technologies open the way for new hand-held devices and inexpensive “dumb” terminals that can connect to the Internet.
Mauboussin notes that he always acknowledged that some network effects are stronger than others and that in technology the effects tend to have a shorter life span than elsewhere.
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FRIDAY: Examining three more myths about tech stocks.
