How to Profit from the Next Investing Bubble

"Bubble Alert! LinkedIn IPO Doubles" -- Wall Street Journal

"Internet Bubble Brings Back Dubious Metrics" -- Reuters

"LinkedIn's Sizzling Debut: Memories of Another Bubble" -- The Economic Times

"Social Networks Bubble Away" -- Financial Times

If there's one word that gets investors' attention, arousing not only fear of catastrophic losses, but also overwhelming greed, it's "bubble." Over countless boom and bust cycles, investors have learned that bubbles will form in any market, from the Dutch tulip craze to the dot-com crash to our recent housing fiasco.

So when LinkedIn (NYSE: LNKD) went public last week, closing at an astronomical 37 times last year's sales at the end of its first day of trading, fears of a new bubble on the rise spread throughout the market. The leery eye most investors are casting toward the next wave of technology darlings is understandable; this ain't the first Internet-bubble rodeo. Only a decade ago, the dot-com bubble burst, and the Nasdaq plunged by 78% in two and a half short years.

Memories of bubbles past
Worse yet, back in 2000 the bubble was unavoidable. The false promise of a new golden age of technology that would make workers vastly more productive, ushering in a sustainable economic boom, propelled all stocks forward. Coca-Cola, that venerable old consumer staple, traded for 60 times normalized earnings. 60 times earnings!

If social tech companies and other Internet darlings are once again partying like it's March 2000, does that mean that it's too late to find big gains in tech stocks without paying wildly speculative prices on the next too-good-to-be-true growth story?

Of course not!
In the dot-com heyday, market caps at Microsoft (Nasdaq: MSFT) and Cisco (Nasdaq: CSCO) both broke the $500 billion barrier. But today's most well-known social web darlings -- Facebook, Twitter, Zynga, Groupon, and LinkedIn -- command a combined market value of around $110 billion at today's trading levels. 

Assuming the four other companies joined LinkedIn, went public, and all saw their share prices double, they'd still only be worth about $210 billion in total. That might form an overheated group, but it would only constitute 10% of the Information Technology segment of the S&P 500. Dot-com era Microsoft and Cisco alone would equal 50% of today's entire S&P technology segment!

Back in 2000, the emergence of a transcendent new technology, the Internet, boosted valuations on nearly all technology leaders. Today's transcendent technology -- new forms of social media and cloud computing -- are pressuring the values of an already established group of technology leaders. Thus, while companies like Facebook and Twitter soak up media attention, their relative price gains pale in comparison to the stock losses seen at leading companies like Microsoft, Hewlett-Packard, and Cisco.

This presents a huge opportunity for us.

See, while most technology companies continue growing earnings, their market values are growing much more slowly, if not shrinking outright. To see this idea in action, look at how much the 10 largest technology companies from 2008 have seen their P/E ratios compress.

Source: CapitalIQ, a division of Standard & Poor's. Reflective of May 19, 2008 and May 13, 2011 closing prices.

The out-of-this world selling prices seen in social media stocks aren't propelling other tech stocks forward. Instead, social media companies are living in their own separate "bubble," while the largest technology companies see their P/E ratios descend to the cusp of single digits.

That's where opportunity lies
The fears surrounding the largest technology companies are often mutually exclusive, yet a wide swatch of these companies have seen their stocks beaten down. Consider that Microsoft, Intel, and Hewlett-Packard all trade for only around 10 times earnings, largely on fears that smartphones and tablets will sap their growth over the next decade and eliminate PCs. That mobile revolution could prove well-founded; smartphone makers sold more than 100 million smartphones handsets in the first quarter, and growth rates remain astounding.

However, at the same time, the two leading companies of the mobile revolution, Apple and Google, have seen their P/E ratios slashed in half over the past three years. In the March quarter, Apple grew net income 92% versus the previous year, yet it only trades for about 16 times earnings! Could you imagine Microsoft trading for 16 times earnings when its earnings were growing 92%? In the entirety of the dot-com bubble, Microsoft only posted earnings growth that exceeded 92% once. IBM, a company now delivering on a plan to double earnings per share between 2009 and 2015, still can be had for 14 times earnings.

Therein lies the key to profiting from a social media bubble. While blazing-hot IPOs will garner much of the media attention over the next year, they're only one niche of the overall technology space. Unlike 2000, when the bubble spread far and wide, the stocks of today's actual tech leaders are stuck in the mud. If companies like Apple and IBM keep growing profits at outsized rates, the market can't continue to ignore them in favor of new hot IPO -- not for long, anyway. Take advantage of the real investing opportunity in technology while it lasts.

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