Stay Wired to Tech
Every portfolio needs technology stocks. But don’t go wild.

Mr. Glassman is editor of TechCentralStation.com.
December 18, 2001 8:00 a.m.

oes anyone really need proof that the high-tech craze is dead?

If so, it came with the news that Henry Blodget, the handsome, 34-year-old Merrill Lynch analyst with the wavy Richard Gere hairdo, was being investigated by New York's attorney general for allegedly misleading investors. Merrill was a late convert to Internet stocks, then embraced them ferociously, putting its imprimatur on such dubious propositions as eToys and Pets.com (both now defunct) and encouraging its Main Street clients to get on the Internet bandwagon just as it was headed for a ditch. Blodget boosted stocks such as InfoSpace Inc., a vendor of "content" that loses more money every year. InfoSpace peaked above $250 a share two years ago and now trades at $2.19.

Of course, Blodget wasn't the only high-tech enthusiast who got it wrong. Mary Meeker of Morgan Stanley, whom Fortune magazine called "the unquestioned diva of the Internet age," kept recommending stocks such as Priceline.com and FreeMarkets all the way down. Priceline, which traded at $165 in 1999, closed Friday at $5.37.

Since mid-March 2000, the Nasdaq 100 — an index of the 100 largest companies on that tech-heavy exchange — has fallen 63%, compared with an increase of 2% for the Dow Jones industrial average. You can hardly blame investors for never wanting to go near a tech stock again.

But that would be a big mistake. Every portfolio needs technology stocks — for the simple reason that tech still represents a big chunk of the stock market and is responsible for two-thirds of the growth in the economy. Here's what to know before you buy:

Tech is a sector, not a retirement plan. So diversify. Currently, the value of all listed tech stocks is a little less than one-fifth of the value of the entire market, so if you want a portfolio that looks like the market and the economy, then tech should make up somewhere between one-sixth and one-third of your portfolio. The investors who got into big trouble over the past few years were the ones who loaded up on highflying tech stocks. If tech accounts for half of your portfolio and the rest is spread evenly over other sectors, then you are probably down by 20% to 25% this year. If tech accounts for one-fifth (as it should), then you're down about 12%. If you're still overloaded in tech, pare your portfolio immediately. Take the tax loss.

Tech doesn't have a patent on volatility. Practically every sector of the stock market — from oil service to health care to machine tools to tobacco — is more volatile than the market as a whole. Invest in a single sector, or just two or three, and you are assured of a wild ride. Since the beginning of the year, the Dow has swung between a high of 11,338 and a low of 8,236. The low, then, was 27% less than the high (think of a stock trading between a high of $57 and a low of $41 for the year — not particularly volatile). Using Dow Jones data, I calculated that the low for tech stocks this year was 60& below the high — very volatile.

But look at the gas utilities sector, where the low was 74% below the high; or coal, where the difference was 59%; securities brokers, 53%; advertising, 47%. So far this year, stocks in the consumer-services sector are up an average of 54% and water utilities shares are up 40%, but the advanced industrial-equipment sector has fallen 48% and non-ferrous metals stocks are down 39%.

The message is that individual stocks and individual industries offer a gut-churning voyage in the short term. Always. The only way to smooth the journey is to own a wide variety of sectors, so that the losses are balanced by gains.
Don't buy companies that haven't made money. Investors found trouble when they tried to bet on companies with no history of earnings. This is not as crazy as it sounds. After all, economists say that the value of a company's stock is determined by the sum of all the earnings the firm will glean over its lifetime. It's the future that counts. That's true, but there's no way to tell the future, so the best evidence we have is the past, and a history of losses is not very reassuring. Venture capitalists who know a firm inside out can make high-stakes gambles on companies with no profits, but small investors absolutely should not. Blodget was fond of InfoSpace even though it lost $29 million in 1998, then $80 million in 1999, then $280 million in 2000. The company will lose money again this year. Who needs it?.

Not all high-tech companies are clunkers. Back on April 27, 1997, I wrote about a remarkably simple system for investing in tech stocks, developed by Leslie Douglas of the venerable Washington firm Folger Nolan Fleming Douglas. Under the Douglas Theory, you put equal amounts into the five largest stocks — in terms of market capitalization (or value according to investors) — on the Nasdaq. At the time, those stocks were Cisco Systems, Intel, Microsoft, Oracle, and MCI (later merged into WorldCom). In the 4 1/2 years since, this portfolio of five high-tech companies has returned 148% while the Dow has returned just 44%.

Finding the Winners
Many tech stocks have been huge long-term successes. An investment of $1,000 in Dell Computer Corp. in 1991 is worth more than $100,000 today. Cisco, despite falling by three-quarters from its high in 2000, has still returned more than 15,000% in the past decade. Adobe Systems Inc. has lost two-thirds of its value since late 2000, but it's still up 237% over the past five years. Like any other sector, tech has winners and losers.

How to find the winners? The standards are the same you should apply to any company: a strong record of rising earnings, a solid balance sheet, strong management, top-notch products that are not apt to draw a lot of competition, and a decent stock price. In fact, Adobe, maker of such software as PageMaker, Photoshop, and Acrobat, may be a good choice. The firm has been profitable since 1986, with earnings rising in every year but one since 1992. Adobe has no debt, $576 million in cash, and profits that have been increasing at a 16% rate over the past 10 years and are estimated by Value Line to do even better in the five years ahead. The stock, however, has dropped by more than half from its 12-month high and trades at a price-to-earnings (P/E) ratio of 30. It's not exactly cheap, but it doesn't seem overpriced, either.

Another profitable high-tech company is VeriSign, whose earnings jumped from $0.03 a share in 1999 to $0.48 last year to an estimated $0.65 in 2001 and $1.16 in 2002. VeriSign is the exclusive registry for .com names through 2007, and it provides digital security for giant customers such as AT&T, Visa, and Eastman Kodak. The company also has no debt and a ton of cash, and it closed Friday at $40.99, down from an all-time high of $258.50 last year.

William Miller, the generally conservative manager of Legg Mason Value Trust, a superb mutual fund that has beaten the S&P's 500-stock index for the past 10 years in a row (and may do it again in 2001), owns such tech stocks as Dell, Amazon.com, and IBM. Amazon has intrigued me for years; it is by far the best-run e-commerce company in the world. Yet, while sales keep rising, profits have been elusive. Amazon closed at $11 on Friday, down sharply from a high of $113 during the Blodget-Meeker glory days. Miller bought more shares during the third quarter.

Amazon doesn't meet our profit test, but the prices of money-making companies like VeriSign have fallen into the realm of reason. For a company that could reasonably earn $3 a share by 2005, a P/E ratio today of 60 is not screwy — though the stock is definitely a high-risk proposition. That's the case as well with attractive software companies such as Cognizant Technology Solutions Corp. (no debt, a history of rising earnings, and a P/E of 35) and well-managed computer-system providers such as Jack Henry & Associates (no debt, 12 straight years of growing earnings, and a P/E of 31).

Individual techs are so risky that considerable diversification within a tech portfolio is essential. An easy way to get it is by owning the Nasdaq 100 Index Tracking Stock, an exchange-traded fund (ETF) listed on the American Stock Exchange under the symbol QQQ. Think of QQQ as a mutual fund that owns 100 companies, the vast majority of them large high-techs. Currently, Microsoft accounts for 12% of the assets; Intel and Qualcomm, 6% each; Cisco and Oracle, 4% each.

Since its inception less than three years ago, QQQ has had its ups and downs. In 1999, it gained 82%; in 2000, it lost 37%; and it's down 32% so far this year. But for long-term investors, it represents the easiest — and probably the best — way to own the sector. Expenses are only one-fifth of one percentage point a year, but, of course, you have to pay a brokerage commission when you buy.

Don't give up on techs, but even at these prices, don't get carried away. Your holdings may be spread out among lots of techs, but your non-techs should outweigh them in dollar value by 3, 4, or 5 to 1.