Earlier this month we marked the third anniversary of the peak of the Nasdaq composite index, which has dropped from over 5000 to about 1300.
Investors can be forgiven for never wanting to own another high-tech stock for the rest of their lives. But that would be a big mistake. While many technology firms turned out to have chimerical business plans and shed 90% or even 100% of their stock prices (the Nasdaq has shrunk by about 1,000 companies), others have retooled, hunkered down, cut costs, invented new products, and grabbed market share.
For the fourth quarter of last year, 84 of the 208 publicly traded Internet companies made a profit, according to Pegasus Research International, including Lending Tree (TREE), the online mortgage broker, whose price has quintupled in the past three years, and Digital River (DRIV), which manages online software sales for big companies and has doubled in price since May.
Forged in a terrible crucible — the first recession in 10 years, terrorism, war, and a bubble to end all bubbles — many of these survivors became hardened and robust. I’ll get to more of them in a second, but first a little perspective on the ballyhooed third anniversary.
The Nasdaq’s volatility should not come as a surprise. Its companies are smaller and riskier than those of the New York Stock Exchange — though there are some notable exceptions, including the largest company, in terms of market capitalization (or shareholder value), on any stock market, Microsoft (MSFT). Higher risk generally means higher reward, but also a bumpier ride. In the past 30 calendar years, for example, the Nasdaq has risen by at least 20% 12 times and fallen by at least 20% five times.
Overall, despite the huge decline since 2000, the index has still doubled since 1992, quadrupled since 1987, and sextupled since 1982. And since 1996, the Nasdaq 100 index — comprising the largest 100 non-financial companies on the Nasdaq Stock Market, according to market capitalization — has significantly outperformed the Dow Jones industrial average and the benchmark Standard & Poor’s 500-stock index.
Thanks in part to the shakeout of the past few years, among the leading stocks of the Nasdaq 100 today are a coffeehouse chain (Starbucks, SBUX), an adult-education company (Apollo Group, APOL), a payroll processor (Paychex, PAYX), several retail chains (including Bed, Bath & Beyond, BBBY, and Staples, SPLS), a uniform supplier (Cintas, CTAS), a grocer (Whole Foods Market, WFMI), and a maker of cardboard boxes (Smurfit-Stone Container, SSCC), as well as more familiar tech, biotech, and telecom companies.
Still, the Nasdaq 100, which you can buy as an exchange-traded fund, or EFT, under the symbol QQQ on the American Stock Exchange, is made up mainly of tech stocks — one-fourth are in the software business, one-third in computer hardware.
While the Nasdaq 100 has dropped 78% during the past three years, CBS Marketwatch calculated that 30 of its 100 stocks actually rose in price, led by Apollo, up 353%; Petsmart (PETM), the pet-products retailer, up 221%; and Express Scripts (ESRX), pharmacy benefits manager, up 201%. And the Wall Street Journal recently announced that the five best-performing companies of last year included three Nasdaq firms: Corinthian Colleges (COCO), career training, up 85%; Dreyer’s Grand Ice Cream (DRYR), also up 85%; and Expedia (EXPE), the travel website, up 79%. Expedia, by the way, was also up 325% in 2001.
And, just as Nasdaq isn’t all tech, tech isn’t all Nasdaq. The largest tech stock on the New York Stock Exchange, International Business Machines (IBM), rose an annual average of 21% over the past 10 years — about twice as much as the S&P 500. And the No. 1 stock of the past decade was — incredibly enough — AOL Time Warner (AOL), with an average annual return of 50%. An investment of $1,000 in America Online on Jan. 1, 1993, became $57,227. Seven other tech stocks in the Journal’s top 20 for the past decade: Dell Computer (DELL) was fourth; Qualcomm (QCOM), wireless products, was sixth; USA Interactive (USAI), media, was 10th; Maxim Integrated Products (MXIM), integrated circuits, 13th; Emulex (ELX), digital storage, 16th; Oracle (ORCL), business software, 18th; and Altera (ALTR), programmable logic devices, 19th.
The truth is, some tech stocks have done extremely well over the past decade — and even the past year. For example, eBay (EBAY), the online auctioneer, has risen by one-third in the past 12 months, while Amazon.com (AMZN), the biggest Internet retailer, has gone from $16.31 to $24.71. Still, that’s little solace for investors who bought eBay in 2000 at $120 or Amazon in 1999 at $113. Anyway, past is past. What about the future of tech stocks?
I’m optimistic, but tech investors need to follow some careful guidelines:
1. Technology is a sector, not a retirement plan, so don’t go wild. Depending on how you define it, high-tech represents between one-seventh and one-fifth of the total value of the S&P 500. A good rule is that tech stocks and funds, including biotech, should make up no more than 20% of your holdings. But just as you shouldn’t go overboard, don’t go underboard either. Technology is an important part of the U.S. economy — the most important part, in my view. To have little or no tech (especially now with prices so depressed) in your portfolio is an inexcusable error.
2. Make sure your tech stocks have solid balance sheets. The current slump in tech sales could go on longer and could worsen. Be sure the stocks you own can weather the storm. The best of the companies have superb finances, thanks to all that cash they raised in their initial public offerings and to the nature of their businesses, which often involve low marginal costs (that is, low expenses for adding sales). Take eBay. At the end of last year, it had $1.2 billion in cash and virtually no debt (just a $15 million loan). Better still, eBay generates cash by the fistful because its requirements for making new capital investments in plant and equipment are low. That’s true as well for Dell, which is one of the few companies with a top A++ rating from Value Line for financial strength. Dell had $4.3 billion in cash at last report, and it generated about $2.5 billion in cash flow in 2002 with only $300 million in capital spending. On the other hand, I worry about the staying power of a company like DoubleClick (DCLK), a leading Internet marketing firm. It has sound management and a good business, and it made a profit last year, but its balance sheet is troublesome, with $163 million in debt and $369 million in cash (down from more than $600 million in the last two years). If there’s one clear lesson from the past three years, it’s that fundamentals count.
3. Still, feel free to own a few tech stocks just because you love the business. That’s always been my view with Amazon, which offers the best service of any retailer in America: courteous, personal, a little pushy but always conscious of what you want — and you never have to talk to a salesperson. My latest infatuation with a great Internet idea is Netflix (NFLX), a lending library with 13,000 DVDs. You pay $20 a month to take out three movies at a time. When you’re finished, just send the DVD back and you get another, and there are no late fees. Netflix is a hybrid that could not exist without the Internet — which is where you place your orders — but that also uses the most traditional means of delivery, the U.S. Postal Service, for serving more than 1 million customers. Netflix went public only in May, and it now trades back near its IPO price after collapsing last fall. It’s still unprofitable, and it has provoked competition from Wal-Mart Stores (WMT), among others. So this is a risky proposition, but not one you should reject out of hand.
4. Also in the high-risk department: Look for beaten-up techs that could reemerge as champs. John Buckingham, editor of the Prudent Speculator, the best-performing newsletter over the past 20 years, has just recommended Novell (NOVL), which sells Internet-based business software. Novell’s chief financial officer, Joseph Tibbett, entered the management hall of fame, as far as I am concerned, when he said recently: “The crystal ball is just too cloudy. We are not giving any guidance on the second quarter and subsequent quarters. There’s enough confluence and confusion in the marketplace that it doesn’t make sense to try and predict the company’s performance.” And Novell’s chief executive said, “I am building this company for the future, not for the next quarter.” Investors rewarded these forthright statements by immediately knocking 15% off Novell’s value, and the stock is down by nearly half since early January. But Buckingham notes that, while Novell lost money last year, it is “debt-free and sitting on a mountain of cash.” It also registered positive cash flow and, in the past, has been very profitable. Also on Buckingham’s list: Apple Computer (AAPL) and Sun Microsystems (SUNW).
5. Beware of technology mutual funds. As fickle investors bailed out of these funds, their managers retooled, stretching their definitions of “tech,” or moving heavily into cash. A good example is Kinetics Internet Fund (WWWFX), whose top holding at the end of last year was Kroll Inc. (KROL), a perfectly decent company, but its line isn’t technology; it’s consulting on business security. The No. 5 holding is Leucadia National (LUK), a mini-conglomerate with interests in finance, wine, and manufacturing. The fund’s manager, Peter Doyle, says he’s devoted to Benjamin Graham-style value investing, and that’s fine, but it hardly justifies owning so many non-tech stocks and keeping about one-fourth of the fund’s assets out of stocks entirely. That’s market-timing. Similarly, Royce Technology Value (RYTVX) managed to hold its losses to 13% last year, partly by keeping 18% of its shareholders’ money in cash. When I buy a tech fund, I expect to own tech stocks. I can do my own cash allocation, thank you.
Using screens on the Morningstar.com website, I searched for tech funds that had a manager with at least three years’ tenure, returns of break-even or better for the past five years, at least a four-star rating, and expenses no worse than average. I found exactly one: Dreyfus Premier Technology Growth (DTGRX). Understand that it’s awfully risky. It has suffered losses of 25% or more in eight of the past 10 quarters, but overall it’s returned an annual average of 3% for the past five years, beating the S&P by 6 percentage points. The portfolio is concentrated (just 38 stocks), but sensible and fair, with only 5% cash. The top-five holdings at the end of last year were Microsoft; UTStarcom (UTSI), a wireless equipment maker that concentrates on the China market; Taiwan Semiconductor Manufacturing (TSM), which makes microchips; Dell; and Cisco Systems (CSCO), the Internet infrastructure provider, which, despite the poor economy, earned $2.8 billion last year on $19 billion in sales and remains one of America’s best companies. One hitch: the “A” version of the Dreyfus fund charges a 5.75% load and 1.55% in expenses.
6. Diversification is a must for technology, so lean toward ETFs — that is, index-style funds that trade like individual stocks and carry low expenses. The best choices are QQQ itself, about three-quarters of whose assets are technology (including biotech and telecom); iShares DJ U.S. Technology (IYW), which mimics the Dow Jones technology index; and SPDR Technology (XLK), which owns the tech stocks that are part of the S&P 500. The only major difference between iShares and SPDR is that the latter includes traditional telecom companies, including the giant regional Bells like Verizon (VZ), which is among its top five holdings, and SBC Communications (SBC). As a result, iShares is a purer play and more concentrated. Microsoft represents 18% of its assets; IBM, 11%; Intel (INTC), the semiconductor leader (and a stock of which I have never been fond because of its huge capital- spending needs), 9%. Overall, the top five holdings represent more than half the value of the fund and the top 10, two-thirds. That’s another problem with tech: It’s hard to avoid portfolios, either managed or index, that aren’t top-heavy. If you own a lot of Microsoft, Intel, and Cisco in your other, general mutual funds, then realize that you’re going to be owning a whole lot more if you buy iShares or SPDR Tech.
In the end, the paradox is that, once you have gotten over your fear of technology, you find that there are really no easy ways to invest in it. My own preference is a mix: an EFT or two, some bright-idea stocks, some companies like Amazon that could be powerhouses of the U.S. economy in five years or more, and a few beaten-up values. But however you do it, do tech.
— James K. Glassman is a fellow at the American Enterprise Institute and host of TechCentralStation.com. Of the stocks mentioned above, he owns Microsoft, Dell and Netflix; he also owns QQQ and SPDR Technology. This column originally appeared in the Washington Post.