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How Tech Stocks Can Change Their Stripes
A New Category: "Value Tech" Stocks
Like many other industries, the investment world has a way of pigeonholing companies into categories. For example, since it went public in 1985, Microsoft has been considered a "great growth company." Intel has been viewed as a way for investors to ride the personal computer growth wave.
But what happens when such companies change into something other than the popular image? The answer can be investment opportunity, because many investors and analysts don't revise their perceptions as fast as companies change. This is what may have happened in the recent technology slowdown, when long patterns of growth at Microsoft, Intel and other companies collided with tech sector weakness and a slowing economy. According to Russell US equity portfolio manager Dennis Trittin, some major technology growth stocks were punished so severely by the market that they become attractive for their value. In effect, they dipped into a new and mostly unfamiliar category of "value tech" stocks.
When Fallen Angels Crawl
In studying the Nasdaq's recent crash, Trittin identified two distinct phases. The first occurred in the third and fourth quarters of 2000, when high-flying growth stocks like Microsoft and Intel produced disappointing earnings and turned into "fallen angel" stocks. This happened before most analysts were aware of the severity of the economic downturn. In the second phase, which occurred in the first four months of 2001, the slowdown accelerated and a host of other tech stocks tumbled, with many also announcing weak earnings. But in this second phase, the fallen angels that had previously taken their lumps outperformed the tech sector as a whole and even the entire market. That's because he had the foresight to view them for their intrinsic value, even as their earnings growth forecasts remained cloudy.
Trittin makes a few points about how to identify "value tech" stocks.
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- They can be even more cyclical than the economy as a whole. One of the first warning signs of the economic slowdown was weak sales of personal computers, upon which both Microsoft and Intel depend for growth. PCs now appear to be a cyclical industry, rather than the straight-line growth generator of the '90s. The stock market generally values cyclical earnings at lower price/earnings (P/E) multiples than steady earnings growth. Some growth managers shun cyclical earnings, even in strong companies.
- Their overall rates of growth may be slowing somewhat with business maturity, regardless of cycles. "A value tech company has lower forecasted growth rates and more cyclical earnings patterns than the tech sector as a whole," Trittin said.
- They are fundamentally strong companies with potential for long-term earnings growth, even if near-term earnings may be weak or uncertain. The main attraction of these companies remains earnings — not assets, acquisition potential, low debt or other traditional indicators of "deep value."
- Stock prices have fallen far enough that P/E ratios are below the industry average. For example, as Microsoft stock tumbled in 2000, its P/E declined from about the mid 40s to the low 20s. The software industry currently has a P/E in the 30-35 range. So, the decline turned Microsoft from a high-priced company into a value opportunity. (Microsoft's stock price has since increased to a point at which its P/E is on par with the software industry.)
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Managers Who Think "Outside the Box"
Trittin observes that it is difficult for even an experienced portfolio manager to pick the bottom in a value tech stock, so courage and patience are virtues. He also observes an interesting pattern in how large institutions trade these stocks. Growth managers and portfolios will cast out a Microsoft or Intel when it becomes a fallen angel. But value managers typically won't take up the slack, because most don't follow the tech sector. "These stocks don't have natural buyers among value investors," he says. The result can be a temporary void in demand, which creates even better value for a bold manager who thinks "outside the box."
Trittin also believes that "the big news later in 2001 will be more value managers talking about tech stocks." The tech sector has declined so much in the past year that Russell value benchmarks will capture more tech emphasis on June 30, when US equity indexes undergo their annual reconstitution. This may motivate some value managers who are attentive to these benchmarks to increase their emphasis in tech. Otherwise, their performance could lag benchmarks in the next major tech rally.
The emergence of "value tech" shows how important it is for portfolio managers to constantly reassess changing conditions in today's markets. Just because stocks get stereotyped doesn't mean your investment strategies need to be stuck in an outdated strategy. The best active managers are always alert for information that defies conventional thinking.
Date of first use: 05/11/01.
Past performance is not a guarantee of future performance.
This is a publication of Russell Investments Canada Limited. It should not be construed as investment, legal, or tax advice. The contents are intended for general information purposes only, and you are urged to consult your own investment, legal, or tax advisor concerning your own situation and any specific investment questions you may have. For further information about these contents, please contact Russell Investments Canada Limited.
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