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Fleeing tech for the wrong reasons
Investors are dumping tech stocks this year despite many positive signs. Fault accounting rules -- and investors still looking for the outsized returns of the '90s.
By Timothy Middleton
Is it a fire sale or a firestorm?
With the Nasdaq Composite ($COMPX) down more than 10% so far this year, investor flight from the technology sector -- the market's dominant theme at the start of this century -- has resumed.
The second-biggest mutual fund that specializes in tech stocks, Seligman Communications & Information A (SLMCX), saw assets shrink 12.3% in the first quarter. At $3.4 billion, they are about one-third their level at the end of 1999.
Paul H. Wick, the fund's manager, is flummoxed. "Tech companies have more cash on their balance sheets today than they've ever had," Wick says. "There have been more large share repurchases in tech than there have ever been. Insider selling is down very heavily."
Indeed, last week IBM (IBM, news, msgs) announced a $5 billion share buyback, signaling that it thinks its stock is too cheap.
These signs should buoy investor confidence. But Wall Street is oblivious.
"Technology and science will outperform the market over the next 10 years," insists Dave Carlsen, co-manager of the Buffalo Science & Technology Fund (BUFTX) fund. "This is where innovation takes place, and innovation will be rewarded through higher growth."
Having greatly reduced my personal exposure to technology in the bear market, I began buying the sector again last November. I expect it to deliver returns at least 25% greater than the market over the coming decade -- annual growth around 9% to 10%, compared to around 7% for stocks in general.
The GAAP gap distorts reality
Even at today's low prices, I don't think tech stocks and the funds that own them are cheap. But I think the prices are reasonable; usually, they are dear. Securities prices follow earnings, and faster earnings growth translates into greater total returns.
The market's current view of tech earnings is distorted because of the growing gap, dare I say it, between GAAP and reality. Generally accepted accounting principles don't capture the nature of technology businesses. They, like commercial real estate, should be judged on the basis of free cash flow. On that basis, tech is doing just fine.
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The GAAP gap is greatest in the software industry, and Wick has plunged 43% of his assets into this group. One of his current favorites is BMC Software (BMC, news, msgs), a maker of enterprise-management software. The company has cash reserves equal to $6 a share and recently restructured to save $120 million, equal to more than a year's worth of profits.
"Their operating earnings for the March 2006 fiscal year should be in the neighborhood of $1 a share," Wick says, giving the $16 stock a price-to-cash flow ratio of 16. "This is an incredibly cheap stock, and there are an awful lot of BMC's in the software industry."
BMC's price/earnings ratio of 38 makes it appear expensive. But GAAP earnings are misleading. Software companies sell their products on a multiyear subscription basis. GAAP requires them to formally book sales months after they've actually collected the revenue.
"Microsoft (MSFT, news, msgs) is trading at 15 times free cash flow; that's not particularly expensive," Wick says. "Cisco Systems (CSCO, news, msgs), same story. The stock has gone nowhere for years, and they're not growing 30% like they did in the decade of the 1990s. But they're doing 9% to 10% growth, and the company is buying back stock in a big way."
(Microsoft is the publisher of MSN Money.)
Waiting, in vain, for '90s-style growth
Another negative against tech companies at the moment is their heavy reliance on stock options to retain and recruit employees. The Financial Accounting Standards Board is requiring that options be accounted for more strictly, another reason GAAP and tech don't mix.
Wick predicts tech companies increasingly will report so-called pro forma results, which filter out some items not related to regular business operations, rather than GAAP earnings. "The analyst community is inevitably going to look at pro forma and not GAAP results," he says. Options "are a whole lot of excitement over nothing."
Carlsen blames tech's market woes on the continuing hangover from the bursting of the Internet bubble in 2000. "It's our opinion that demand is going to be more normal going forward, meaning 10%-ish growth, rather than a sustained 15% growth environment, which I would say is a supercycle demand environment. That's another word for 'bubble,'" he says.
Tech investors, in short, are holding out for something they're not going to get -- a return to the 1990s. But no stock investors are getting 1990s-size returns. Eventually this cold reality will sink in, and the market will revalue tech prices upwards.
A tax holiday for fund buyers
Meanwhile, the massive redemptions at tech funds have forced them to book capital losses as they sold shares to pay back investors. Wick is sitting on $1.6 billion of these so-called tax-loss carry-forwards.
"Given the current size of the fund, we could generate roughly 50% of cumulative capital gains without our shareholders having to pay any taxes," he says. That's not a trivial consideration. The average tech fund holds a given stock only about six months, making it very tax-inefficient. A tax holiday will be an added bonus when the sector revives.
I should stress that I'm not calling for an immediate or even imminent surge in tech stock prices. If I were, I'd take a hard look at the Technology SPDR (XLK, news, msgs), an exchange-traded fund that follows the S&P Technology Index.
I did make such a call last October, and I was wrong. I bought the tech spider in my own account in November for around $20.50 and sold out in January at $20.78. (Last week it was trading around $18.80.)
This was a trading ploy, not a long-term investment. I also bought the Buffalo Science & Tech fund at the same time, and that is a long-term commitment. I can't foresee the next time tech will dazzle, but, between here and there, I expect the sector to deliver greater returns than the market.
At the time of publication, Timothy Middleton owned the following securities mentioned in this article: Buffalo Science & Technology Fund, Microsoft.
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