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Big-Cap Tech Stocks
Are a Sucker Bet

Wall Street Journal, March 14, 2000

By Jeremy J. Siegel, a professor of finance at the Wharton School and author of "Stocks for the Long Run" (McGraw Hill, 1998).

Until Monday's sell-off the Nasdaq Stock Market had enjoyed quite a run, surpassing 5000 for the first time even as the Dow Jones Industrial Average went through a correction. But are the high valuations of the tech stocks that drive the Nasdaq index justified? History suggests not.

In the late 1960s Polaroid was at the top of its game, dominating the photographic field and enjoying one marketing success after another. Investors bid the stock up to an unheard-of 95 times earnings. Never before had a large-capitalization stock been priced so high. But Polaroid's earnings growth had exceeded 40% a year over the previous 14 years, and the future seemed even brighter.

Most Valued Stock

IBM became the most valued stock in the world in 1967 and held on to that position for more than six years. The dominant computer manufacturer enjoyed enviable margins and virtually no competition. Its stock value reached 50 times earnings, a striking multiple for the world's largest company. But why not? IBM had regularly cranked out 20% annual increases in earnings from the early 1950s, and the future obviously belonged to technology.

Yet investors who purchased these and many other stocks when the future looked brightest had much to regret. Polaroid faltered badly, and its stock gave investors negative total return over the next 30 years. And despite IBM's comeback under CEO Lou Gerstner, the company's return has been less than half that of the Standard & Poor's 500 index over the past generation.

These examples are typical. History has shown that whenever companies, no matter how great, get priced above 50 to 60 times earnings, buyer beware. A few stocks of the nifty-50 era subsequently outperformed the market, but in that venerated group no stock that sold above a 50 price-to-earnings ratio was able to match the S&P 500 over the next quarter century. Such great companies as Baxter Labs, Disney, McDonald's, Johnson & Johnson, AMP and Texas Instruments have trailed the averages.

Unsustainable Values

Large-cap companies with price/earnings ratios over 100

Company Market Cap (3/7/00, in bil.) 1999 P/E Est. Growth P/E in 5 years P/E in 10 years
Cisco Systems $452 148.4 29.5% 73.9 40.9
AOL/Time Warner 232 217.4 31.5 100.0 51.1
Oracle 211 152.9 24.9 91.3 60.5
Nortel Networks 167 105.6 20.7 74.5 58.4
Sun Microsystems 149 119.0 21.1 82.8 64.0
EMC 130 115.4 31.1 54.0 28.1
JDS Uniphase 99 668.3 44.0 195.5 63.5
Qualcomm 91 166.8 37.3 61.8 25.5
Yahoo! 90 623.2 55.9 122.6 26.8
15 non-tech 2,361 30.4 13.7 23.8 20.3
S&P 500 11,281 28.6 12.5 23.8 21.3

Source: Bloomberg

But many of today's investors are unfazed by history -- and by the failure of any large-cap stock ever to justify, by its subsequent record, a P/E ratio anywhere near 100. As the chart nearby shows, of the 33 stocks (18 tech and 15 nontech) that have a capitalization over $85 billion today, an incredible nine currently have P/E ratios in excess of 100, and six of those are in the top 20.

Supporters of these valuations point to their fantastic growth and rosy prospects. And indeed, analysts' estimates of future earnings growth, collected by the Institutional Brokers Estimate System, have predicted that these stocks' earnings per share will grow more than twice as quickly over the next five years as the S&P 500.

But once a firm reaches big-cap status -- ranked in the top 50 by market value -- its ability to generate long-term double-digit earnings growth slows dramatically. Schlumberger, an oilfield-service company, was alone when it attained a 10-year growth rate of 35% in the 1970s, but no investor would have been happy picking this stock at the height of its earnings growth in 1980. Merck has been able to reach 10-year earnings-per-share growth rates near 20% in the 1980s. And yes, Microsoft has achieved a 10-year growth rate in the mid-40s. But Microsoft did not reach big-cap status until 1993.

Even if the fantastic long-term growth rates IBES predicts for the tech companies come true, they won't be nearly good enough to sustain current values. I calculated what the P/E ratio of each stock would be, assuming that these earnings estimates not only are realized in the next five years but are even replicated in the following five. To determine the future price of these stocks, I assume that investors expect to receive an average 15% annual return on these highfliers. Given the volatility of these tech stocks, this assumption is reasonable, and it is doubtless considerably less than many investors expect.

The results are not comforting. Even if the earnings estimates are realized, in five years the average P/E ratio of the "over-100 P/E" stocks drops only to 88.6. And three (America Online-Time Warner, JDS Uniphase and Yahoo!) remain over 100. If the IBES estimates for earnings growth can be maintained for 10 years, the P/E of these stocks fall only to the mid 40s. Even though these stocks will by then totally dominate the market, they will be priced at twice the level projected for the S&P 500.

The 15 nontech stocks with market capitalizations over $85 billion look like a much safer investment. I assumed a return of 10% per year, in line with historical market returns. The current P/E of the big-cap nontech stocks is currently just over 30, a bit higher than the S&P 500 (assuming the same 10% return). And their projected earnings growth rate, at 13.7% per year, is just above that of the S&P 500. In five years the P/E of nontech stocks falls below 24, and in 10 years to just over 20 -- a very reasonable P/E ratio considering the increased productivity growth and stability of our overall economy compared with the historical record.

What does all this mean? Our bifurcated market has been driven to an extreme not justified by any history. The excitement generated by the technology and communications revolution is fully justified, and there is no question that the firms leading the way are superior enterprises. But this doesn't automatically translate into increased shareholder values.

Not From Sales Alone

Value comes from the ability to sell above cost, not from sales. If sales alone created value, General Motors would be the world's most valuable corporation. In a competitive economy, no profitable firm will go unchallenged. Margins must erode as others chase the profits that seem so easy to come by now. There is a limit to the value of any asset, however promising. Despite our buoyant view of the future, this is no time for investors to discard the lessons of the past.

Felet med Mosesteorin - SvD-ledare 2000-03-02

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