FOOL ON THE HILL
Last week's share price blow-up by PMC-Sierra illustrates Wall Street's tendency to think short-term about events and not long-term. While the firm's near-term earnings estimates have been revised downward, sell-side analysts would have investors believe that the long-term growth outlook has barely changed. That's because for the pros, long-term estimates are generally just guesses.
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I heard an experienced investor once say that the problem with being a long-term investor is that from the stock market's point of view, the long term doesn't matter -- until it does. The suggestion here is that during a typical trading day, the majority of the participants that make up what is collectively referred to as "the market" are primarily concerned with what amounts to short-term concerns, such as next quarter's earnings estimates or which stocks are getting ready to split or whose Super Bowl commercial is going to be a winner. When the market is open at least, these are the factors that are on "the market's" mind and get worked into the daily business reports and TV shows, not what is expected to happen to stocks five years down the road. Over long stretches of time, though, these daily events are pretty trivial in how they relate to the eventual performance of an investment in a stock. And every now and then, investors get reminded of the ultimate importance of events beyond today's news or this quarter's earnings. Whenever this happens, as it inevitably does, "the market's" response is far from surprising. More often than not, all hell breaks loose. Just like a land-lover who doesn't adjust particularly well to the occasional journey at sea, "the market" tends to have a difficult time making a sudden shift from its habitual short-term thinking to a longer-term viewpoint. As an example, take the market's recent pummeling of broadband communications chip designer PMC-Sierra (Nasdaq: PMCS). PMC-Sierra has been one of the better short-term performers in recent years, being in the right sector at the right time, beating earnings estimates quarter after quarter in 1999 and 2000, splitting its stock in both years, and gobbling up other firms on a regular basis to beef up its intellectual property. In turn, the company's shares rose eleven-fold over the three-year period ending last Thursday. But just one day later, fully one-third of that prior appreciation vanished. PMC-Sierra warned that its revenues will fall about 25% to 30% sequentially from Q4 of 2000 to Q1 of 2001 as many of its networking customers slow down new chip orders in order to work-down their existing inventories. More ominous was the longer-term outlook for two quarters out, with the firm's management commenting that they "have no visibility to speak of" for orders and sales in Q2. Predictably, sell-side analysts reacted by ratcheting down their earnings estimates for PMC-Sierra for the coming quarters and the next two fiscal years. As of this morning, First Call was reporting that the mean estimate for the firm's 2001 EPS had fallen to $0.96 from $1.70 on Thursday, with the 2002 estimate reduced to $1.66 from the previous $2.69. Given the magnitude of the revisions and the visibility loss by management, the mean estimate for the company's long-term growth rate must have surely taken a hit, right? Barely. PMC-Sierra's expected long-term secular growth rate today is 40%, compared to 42% prior to the warning. Some revision. The PMC-Sierra experience illustrates why short-term thinking on Wall Street is so popular -- it's because thinking about the long-term is so darn hard. The panic in the short-term thinking, with the slew of downgrades and estimate changes on Friday helping the trading volume for the firm's shares swell to about four times average, amounted to a yawn on the collective long-term thinking front. Starting with a base of $0.99 in EPS for the just-completed fiscal 2000, the old 42% compounded annual growth rate would have produced $5.71 in EPS in five years. At the new 40% growth rate, EPS is seen at $5.37 five years out. The net effect is a 6% long-term reduction in future earnings. This supposedly justifies the 23% decline in PMC-Sierra's market cap on Friday? No wonder many long-term investors sound so cynical when they question the logic of "the market." This isn't meant to be another Motley Fool diatribe where we drag sell-siders over the coals for being dumb and wrong. I wouldn't want to be in their shoes and be saddled with a job where all you do is try to predict short-term events over and over again, whether you want to or not. In that situation, an eventual failure is almost guaranteed. It's like being a poker player who can never fold and instead must play out and bet on every hand, regardless of how bad it is. No thanks. But in the case of their long-term growth estimates, at least some sell-side analysts openly admit their short-comings. The Wall Street Journal ran a story on this very issue just last week, which included a quote from a Lehman Brothers technology analyst revealing that for most of the analysts he knows, the long-term growth estimate is "generally a meaningless, throwaway number." In other words, if you can't figure out what PMC-Sierra's long-term earnings growth rate is going to be on your own, take heart, because the pros can't either. For the individual investor, there are a couple of take-aways from this long-term growth rate estimate problem and the market's tendencies to think almost exclusively short-term. Most obviously, just like upgrades and downgrades, reported secular growth rate estimates from sell-side analysts should be taken with a grain of salt, if not an entire salt dome. And as a direct consequence, wishy-washy long-term growth estimates are another nail in the already beaten down coffin of the price to earnings growth, or PEG, ratio. The ultimate usefulness of the PEG ratio has been called into question in this space before, typically because of the dangers inherent in using the P/E ratio as a determinant of a company's underlying value or as some kind of predictor of future investment returns. Say what you want about the P/E, but at least it exists. If you take the sell-siders' word for it, it's the long-term growth rates usually plugged into the PEG that actually pose the greater problem, because there's a good chance they are make-believe. Just as that old investor's advice and the PMC-Sierra experience tells us, those long-term factors may end up mattering some day.
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