The day's work of a value investor is to find fallen angels in the stock market. Or in more technical terms, is to find assets in which they can buy $1 of assets for less than a dollar. In today's markets there is some noise coming from some quarters that the technology sector is now a value play.
Unfortunately, investors got into a (bad) habit during the 1990's, where they thought they should buy at any dip in a stock price, particularly a tech stock. This behavior eventually was quite hazardous to their wealth.
As a long-time value investor, I have found stocks become cheap for one of two primary reasons: 1) A stock has experienced some short-term dislocation in which there is a hit to its balance sheet and/or earnings stream. 2) The stock is just a lousy investment. As a value investor you look to avoid #2. In the #1 situation you try to identify a catalyst in which there will be a repair to the balance sheet or earnings dislocation.
In the tech sector, we have seen the price damage. Based on returns in the tech sector as measured by the S&P 500, investors are down 8.3% through June 27, 2006. Focusing on three of the tech giants, we can more specifically illustrate why the tech sector may be a value trap for investors. Microsoft (MSFT) is down 12%, Dell (DELL) is down 21% and Intel (INTC) is down 27%.
On a Price/earnings basis they are 18x, 17x and 14x respectively. These are not exactly outrageous multiples given each of their past histories and compared to 20 x's for the S&P 500. One might be sorely tempted to say these are indeed attractive. Microsoft and Intel also have cash rich balance sheets.
A closer look at these three tech companies based on some other metrics does give value investors some pause. Based on Price/book measures Microsoft is trading at 5.6x book value and Intel is 3.1X, while Dell is a whopping 16x. The S&P 500 is 3.3 times. Couple this with the fact that they pay little in dividends and investors have little to ease their pain while the cycle plays out.
Another measure that folks have used to use to rationalize valuations (and sometimes rightly so) of tech stocks has been the PEG (PE/ 5yr Growth rate) ratio. Based on current market levels Microsoft and Intel are trading near the S&P 500 well above 1.00, while Dell is trading at 0.94. Typically, investors are looking for a PEG ratio of below 1.00.
Unfortunately, for investors earnings growth for Dell this year is -11%, Intel is -35% which makes Microsoft by comparison the bright light at +9%. Unfortunately, the S&P 500 growth rate is at 14%. Assuming estimates for the five-year period are accurate; they are coming from a depressed base and does not offer true growth but a rebound back to par. And technology as a group will exhibit earnings growth in 2006 and 2007 that is shy of the S&P index.
Tech is following its typical cyclical pattern, which runs in approximately 3 year cycles. The difficulty in understanding these cycles is that sometimes worldwide GDP growth impacts the cycle, while other times it is more closely tied to the product cycle. We are now in the latter occurrence.
Currently we are witnessing an increase in supply of tech products (inventories are rising), IT spending is slowing and many tech products and markets are mature. Microsoft's Windows is a mature product and is now hampered by a delay in Vista, their new product. Intel is experiencing a ballooning of its inventories to $3.8 billion. Dell is seeing PC orders dry up as spending is pulling back.
One final note of caution in examining earnings of tech companies is that most of the current estimates do not include the expensing of stock options in the calculation of EPS. This is important in an industry where a disproportionate amount of profits goes to employees by the generous granting of stock options.
In fact, if one were to adjust tech companies for options, they would find earnings significantly lower and returns on invested capital to be poor. It would be quite prudent for any investor to understand the past practices and current prospects of these companies before jumping in to buy these old stalwarts of the bull markets.