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New Paradigm Investing
Am I the Only Sane One Left?

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By Y2Krash
August 20, 2001

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I freely admit that I sometimes get caught up in all the hype and excitement of the markets and lose track of reality. Hopefully I've learned from my mistakes but really, I probably won't know until I look back on it in the future. Were stocks overvalued in 1999/2000? Obviously the answer is yes. PEs and even P/Ss (price-to-sales) well into the hundreds were common place during this period, it is now abundantly clear that there was no way that most of these companies would ever come close to realizing the potential built into these lofty valuations. However, many analysts still tried to find justification and, in their own mind did, often by applying a discounted PE analysis or simply by using relative valuations. I can't tell you how many times I read about analysts forecasting earnings out to 2010, placing a PE of 50 (or higher) on that number and then discounting it back to the present. In go the numbers and poof, Yahoo!'s worth 350 dollars a share.

Yes, it was irrational exuberance and yes, many of us got a big shot of reality right in the teeth over the past year. Now that the irrationality seems to have passed for the time being, the big question is, "When are these former high flyers fairly valued?" I read a lot of commentary on this topic and there's one that is almost universally used by market Bears and Value investors (i.e., Tech bears). It essentially states that although technology valuations have come down significantly over the past year, they have been offset by the decrease in earnings. As a result, the average PE of technology stocks is currently still significantly above historical norms meaning that there could be considerable downside remaining. As most people know, I have not been very optimistic over the short-term market and think that there could still be some more pain to come. However, arguments like the above seem no less ridiculous than trying to value a company by forecasting the most optimistic performance of a company over the next decade or more in order to come to a fair value.

The reason why technology companies' earnings have fallen so much is primarily because many had gotten too big, too fast. When you grow your company based on the assumption that it will experience 100% year over year growth in the coming year and you end up with flat or declining growth, there are bound to be higher costs. The additional employees, added capacity, etc., all combine to squeeze profit margins in the near term. However, this is not a permanent phenomenon but rather a natural result of market cycles. Over the course of the next year, companies will lay off employees, cut manufacturing and other expenses in order to get costs under control. Once this happens, higher profitability will return, even if revenue growth does not.

For example, Network Appliance is only expected to generate $0.11 per share profit in the current fiscal year, a third of what it was last year, which implies a current PE of around 120... not exactly cheap. However, if you believe current analyst estimates, earnings are expected to more than triple in the subsequent year to $0.37 per share, which implies a PE of around 35.

So what will happen to NetApp over the next five years? I don't know but I think that it's a safe bet to assume that some level of growth will resume. If this is the case, then why are some market watchers trying to value technology companies based solely on the current year's estimates and with no expectations for growth in the future? To me, valuing a company by looking one year out is no less ridiculous than trying to do so by forecasting out 10. I have no idea if technology stocks have bottomed or not but I do know that this argument used by market commentators seems like an attempt to scare away unsophisticated investors. I can't imagine that I'm the only one who sees the insanity of it all.

And so I ask, am I the only sane one left and everyone else has gone crazy or is it the other way around?

matt@twostepsfromthenuthouse.com