As tech IPO mania gripped investors during the second quarter, the established elders of the tech world — the very ones responsible for the last bubble in the late 1990s — were decidedly not invited to the party.
Although the Standard & Poor’s 500, an index of 500 of the country’s largest companies, was up 5 percent year to date through June, the tech sector lagged considerably, eking out a 1.6 percent gain. Considering the lowered guidance from tech giants such as Nokia, Texas Instruments and Research in Motion, the sector’s performance is not terribly surprising.
But it’s not just troubled companies that investors have shunned. It’s the entire large-cap tech sector — even companies with strong balance sheets that are still gaining market share and increasing their profit and revenue, though perhaps not as fast as they once did. This has brought bargain-basement prices for blue-chip tech companies that were among the most-loved in the last major tech craze — think Microsoft, IBM, Intel, Hewlett-Packard and Cisco.
“When investors think about the most interesting or compelling tech names, it is not about old-line tech names that have been around for five, 10, 20 years,” said Scott Kessler, head of technology-sector equity research at Standard & Poor’s. “In some cases, people are understandably perceiving big-cap tech names almost like utilities — businesses that aren’t going to go away, but you wonder about their long-term growth prospects.”
The median price-to-earnings ratio for tech stocks going back to 1995 is 23.8, compared with 18.4 for the overall market, according to S&P — meaning that, historically, you’ve had to pay a hefty premium to invest in tech. That’s no longer the case. As of late June, tech stocks were trading at 15 times trailing 12-month earnings, compared with 15.2 for the broader market, according to S&P. The contrast is even starker if you compare tech prices today with where they were during the 1999 tech heyday, when tech stocks generally traded for more than 50 times earnings, according to Artisan Partners/FactSet Research.
“Large-cap tech stocks are very cheap and are currently trading at their biggest discount to their median going back to 1994,” said Sam Stovall, chief investment strategist at S&P. “If you are a longer-term, growth-oriented investor, tech has above-average earnings growth and below-average price-to-earnings ratios.”
S&P has “buy” or “strong buy” ratings on five of six mega-cap stocks (those with more than $100 billion in market capitalization) on the S&P 500, including Microsoft, Apple, IBM, Google and Oracle. It has a “hold” rating on Intel based on the chipmaker’s exposure to the consumer PC market, Kessler said. But overall, S&P is optimistic. During the same week in June that the Federal Reserve cut its 2011 and 2012 economic growth estimates for the U.S. economy, S&P predicted that its recommended mega-cap tech companies would report per-share earnings growth of at least 16 percent in the second quarter.
Despite high hopes for tech revenue and earnings even during muddling economic growth, shares of technology companies — typically considered growth plays — are so cheap that they’re finding vocal fans in prominent value investors.
Whitney Tilson, founder of T2 Partners, fund manager of the value-oriented Tilson Focus Fund, and co-founder of investment newsletter Value Investor Insight, has been adding to his fund’s position in Microsoft this year as the stock has slipped from about $28 at the beginning of the year to $26 at the end of the second quarter. If Microsoft had a slogan, the way Tilson sees it, it might be “Not dead yet.”
In his May presentation to investors, Tilson said it was a “myth” that Microsoft is a dying company. He argued that its core franchises of Windows and Microsoft Office are difficult for businesses to replace, that it’s improving its cloud-computing and search businesses, and that it’s making gains on the gaming front with its Xbox and Kinect systems — not to mention enjoying double-digit revenue and profit growth.
“What’s priced into this stock is that this is a one-time [earnings] bump from the new versions of Windows and Office driving a final hurrah, and it’s all downhill from here,” Tilson said. “I wouldn’t go so far as to say we’re excited about Microsoft — it’s not like Apple in the sense that it’s got products that really get you excited. As investors, we don’t have to be excited about Microsoft to own it at seven to eight times earnings, net cash. We just have to believe it’s not going into a rapid and permanent decline.”
George Sertl, co-manager for the Artisan Value Fund, says it’s taken more than a decade for tech stocks to get back to prices that look appealing to value investors after their late-’90s and early-2000s peaks. Take Cisco, for example. Shares peaked at about $80 in 2000, when it was earning 53 cents a share. To own Cisco, investors were paying 153 times earnings.
“It usually doesn’t work out too well when you pay 153 times earnings,” Sertl deadpanned.
This year, analysts estimate Cisco will earn about $1.60 a share, and with its stock at about $15, it’s trading for about nine times earnings.
Artisan Value Fund’s top holdings are, in descending order, Microsoft, Apple and Cisco. Hewlett-Packard, Ingram Micro and Texas Instruments are also among the top 10. Sertl says investors need to adjust their expectations for the pace of growth in older tech companies that were once highfliers.
“These companies will grow at a slower rate than they have in the past, there’s no doubt — these are huge companies,” Sertl said. “But I think they’ll still grow faster than the economy. And they’re selling at multiples that are usually given to companies that have poor balance sheets, poor return on capital and poor future prospects. That’s the opportunity.”
Of course, a cheap stock price is not in itself a good reason to invest in a company. And large-cap tech companies have certainly had their share of land mines.
In mid-June, Research in Motion, maker of BlackBerry devices, revised its full-year earnings guidance from $7.50 per share to $5.63, triggering a number of analysts to sharply reduce their price targets and earnings estimates. Deutsche Bank analyst Brian Modoff reiterated his “sell” rating on the stock and cut his price target by more than half, from $45 to $20. He called RIM’s products “increasingly dated” and suggested that the company’s co-chief executives are deluded if they think there is “unprecedented interest in their products.”
Shares of onetime cellphone king Nokia have also suffered since it reduced its guidance for the second quarter and full year 2011 because of weak handset sales — an announcement that had ripple effects throughout the sector. In June, Texas Instruments, which supplies chips to Nokia, lowered its revenue and earnings guidance for the second quarter as well — and blamed Nokia for the entire shortfall.
The trick in a market such as this, then, is separating stocks that are unfairly cheap from stocks that deserve to be in the bargain bin.
“There are value traps out there — we’re not touching Nokia or RIM,” Tilson said. “Maybe they’ll rebound, but there’s a very good chance they’ll spiral downward. Their businesses are in full-scale collapse.”
When faced with statements like that, it’s easy to understand why investors get caught up in the idea of an IPO for Groupon or Facebook or other social-networking companies they use every day. So a word of caution.
“Even if a company proves to be very successful, the price one pays for any investment is of critical importance in determining future return,” Sertl said. “People equate a company’s success with a good investment — but if you pay too high a price, you can lose a lot of money.”
Schulte is a writer and editor in New York.