In my most recent column, The Tech Stock Discount, I argued that tech stocks should trade at a valuation multiple lower than that of the rest of the market and, therefore, that fair value for the tech sector is approximately 60% below current levels. Given this belief, you might be surprised to hear that I think the tech sector is a fertile area for value investors -- at least during certain times.
Tech stocks for value guys?
Many people assume that because the most famous value investor of all time, Warren Buffett, shuns investing in the tech sector, all value investors follow his lead. This is not the case. Legg Mason's Bill Miller, the only fund manager to beat the S&P 500 index for the past 13 years running, owns or has owned large stakes in Amazon.com (NASDAQ:AMZN), eBay (NASDAQ:EBAY), Dell (NASDAQ:DELL), and AOL, among others. Three prominent value investors -- Miller, Mason Hawkins of the Longleaf Funds, and Buffett himself -- invested in Level 3 Communications (NASDAQ:LVLT) two years ago (though Buffett slashed his stake by more than 90% last November). Oakmark's Bill Nygren was bottom-fishing in Sun Microsystems (NASDAQ:SUNW) in 2002, and Third Avenue Value's Marty Whitman at the same time owned Tellabs, Sycamore Networks, and Ciena, among others.
As for myself, while I own no stocks in the tech sector today (in fact, I own puts on two tech-heavy indexes, the Nasdaq 100 tracking stock (AMEX:QQQ) and Semiconductor Holdrs Trust), in the past I've owned shares of Dell, Lexmark, Symantec, ValueClick, Register.com, and TheStreet.com, among others.
Now that we've established that many dyed-in-the-wool value investors do, in fact, invest in the tech sector, let's ask why. Aren't we concerned about the many issues Buffett raises, ranging from circle of competence to inability to predict future cash flows? Of course we are, but: a) not all tech stocks are created equal in terms of predictability of future cash flows, and b) sometimes a stock is so cheap that it's worth buying, even if there's quite a bit of uncertainty.
Dell vs. Google vs. McDonald's
Regarding the former, there's a huge difference between, say, Dell and Google. While both are lumped into the tech sector, I would argue that Dell is primarily a manufacturing/assembling, sales and service business, not a technology company. Dell doesn't really care which hardware and software products win the technology wars -- it simply buys, assembles, sells, and supports whatever its customers want. In short, I think the odds are very high -- say, 80%-90% -- that Dell is a major computer company in 20 years. (This is not to say that I recommend buying Dell stock -- as much as I admire the company, I wouldn't buy it at half of today's price.)
Google, in contrast, is a more typical tech company -- one that must invest heavily to remain on the cutting edge or its customers will quickly and easily flock to competitors. Just as Google came out of nowhere to unseat Yahoo! as the leading search engine, so might another company do this to Google. I admire Google and what it has accomplished -- and I'm a happy user -- but I am quite certain that there is only a fairly shallow, narrow moat around its business.
Think about it. What are the odds that it is the leading search engine in five years (much less 20)? 50/50 at best, I suspect, and I'd wager that odds are at least 90% that its profit margins and growth rate will be materially lower five years from now. Yet investors appear ready to value this company at as much as $36 billion, nearly 200 times trailing earnings! Google with the same market cap of McDonald's (a stock I own)?! HA! I believe that it is virtually certain that Google's stock will be highly disappointing to investors foolish enough to participate in its overhyped offering -- you can hold me to that. (For more on Google's IPO, see Bill Mann's take.)
Fertile ground
Despite my reservations about the tech sector, I actually think that it is -- or at least should be -- fertile ground for value investors for the simple reason that most of the investors in the sector are irrational, momentum-driven speculators. Thus, the sector is characterized by wild mood (and therefore price) swings, as investors overreact to favorable or unfavorable developments. While overvaluation has been the more common state of affairs during the past decade or so, there have been a few points -- October 2002 most recently and, to a lesser extent, March 2003 -- when tech investors panicked and all sorts of tech stocks were downright cheap (though I'm not convinced that the sector as a whole was ever undervalued -- one of the reasons why I think there could be another major correction).
Not only does the tech sector offer occasional opportunities to buy 50-cent dollars, but when it returns to favor, one can sometimes sell such dollars for $2, $3, or more, as I discussed in A Value Investor's Secret. Now that's a way to make real money!
Jim Clarke's thoughts on investing in tech stocks
Speaking of making real money in the tech sector, my friend Jim Clarke, a portfolio manager at Brandywine Asset Management, has been doing just that. After making "a fortune" in 2002 -- yes, a year in which the Nasdaq fell 31.5% -- he sold virtually all of his tech winners by January 2004. While he started nibbling at blowups in the sector a month ago, he still remains underweight tech because he shares my belief that valuations will get more attractive.
Jim recently shared with me some of his thoughts about investing in tech stocks. I think they're brilliant, so with his permission I'm sharing them with you:
- We find the tech sector absolutely fascinating, and we are not tech experts by any means and never will be. We wouldn't know what 10 gigabit ethernet was if we stepped on it. There are a lot of value investors who are very uncomfortable with tech because they don't understand the technology, so they write off the sector, which makes it, quite ironically, a great sector for value investors. We don't understand the technology either, but we've found all that's necessary is to understand the financials and look for extremes.
- The sector has great balance sheets with large cash balances and no debt -- there is no other sector like it in that respect.
- The tech sector is characterized by incredible volatility, in part because so many tech investors "don't do valuation." The same guys selling us the stock at 0.5x enterprise value to revenues on a blowup or a scary time seem to have no problem buying it from us at 5x revenues two years later when things get marginally better. This is why tech is our favorite playground when it does its thing every couple of years. It has nothing to do with sector valuation, but everything to do with micro volatility.
- Many value investors, to the extent that they invest in tech at all, crowd into a small handful of stocks. We typically traffic in tech stocks that other value investors have never heard of.
- We've found that the value investors who buy tech stocks tend to fall in love with them when they go up and treat them as something different. They often abandon all sell discipline because tech is something magical, even if they bought them on sound valuation measures. We don't do that. We've sold a lot of doubles that became quadruples, but we don't roundtrip and we don't lose money. I think our hit rate (profits vs. losses) on tech stocks has been north of 80% and the losses have been minor and the profitable ones huge. And very often those sells have been right at the top even though it looked like things were just getting good and everybody loved the stock again. The doubles that became quadruples are the exceptions that are memorable because they're vivid.
Conclusion
The general guidelines for investing in the tech sector are the same as for every other sector: Look for especially out-of-favor areas and companies, where valuations are at multiyear lows, and try to identify the one or two best companies that have good businesses, at least somewhat predictable earnings, and strong balance sheets to weather the storm.
Technology companies are usually unattractive to value investors because, in general, their future cash flows are highly uncertain (and don't even get me started about stock option abuse). However, the cyclicality of the industry combined with the unparalleled concentration of irrational, momentum-driven investors makes the tech sector, ironically, a very fertile area for patient, disciplined value investors.
Longtime Fool columnist Whitney Tilson was long McDonald's stock and calls and owned puts on the Nasdaq 100 tracking stock (QQQ) and the Semiconductor Holdrs Trust (SMH) at press time, though positions may change at any time. Under no circumstances does this information represent a recommendation to buy, sell, or hold any security. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/. The Motley Fool is investors writing for investors.
