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Big Tech Stocks at Bargain Prices
In the 1990s, a small group of technology companies, many of them tiny buds when the decade began, blossomed into the biggest roses the U.S. stock market had ever seen. For example, Microsoft (symbol MSFT ) reached a market capitalization--that is, shares outstanding multiplied by price--of $586 billion by March 31, 2000. That's about 50% greater than the market cap of Apple ( AAPL ), the world's most valuable stock today. Microsoft wasn't alone. At their peaks in 2000, Cisco Systems ( CSCO ) and Intel ( INTC ) each bore market caps just shy of a half-trillion dollars, and Oracle ( ORCL ) and the company then known as AOL Time Warner were at about a quarter-trillion.
But the world has changed. Big tech stocks started declining in the spring of 2000, and, with a few exceptions, they still haven't recovered. Microsoft's market cap is only $236 billion today, and Cisco and Intel are worth just over $100 billion.
The very nature of these stocks has changed as well. In the past, paying a dividend was a sign that a company was dowdy; investors in hot tech firms were only too happy to let smart executives retain and reinvest their profits. Now, however, Microsoft sports a dividend yield of 3.3%--more than Procter & Gamble ( PG ). Cisco yields 2.6%; Intel, 4.1%; and Apple, 2.5%. Moreover, in early March, Apple, Cisco, Intel and Microsoft each traded at less than 11 times estimated 2013 earnings. That's considerably lower than the price-earnings ratios of P&G, Johnson & Johnson ( JNJ ), Duke Energy ( DUK ) and Standard & Poor's 500-stock index as a whole (all prices and related data are through March 7).
In my view, however, the tech giants don't deserve to be ostracized, because they represent some of the best values in the stock market. Many of them still generate double-digit earnings growth, have beautiful balance sheets and have shown that they can adapt to a changing marketplace that, in its latest evolution, is turning from personal computers to computing via mobile devices. At worst, you can collect your dividends while you wait for Mister Market to come to his senses.
Stocks of many tech giants are much cheaper than they were at the nadir of the 2000-02 bear market. In 2002, for instance, Cisco bottomed at just over $8. That year, the company, which makes hardware and software that are critical to the functioning of the Internet, earned $2.9 billion. Cisco now trades at $22, or about 2.7 times its 2002 price, yet its annual profits exceed $10 billion. And because Cisco has been buying back its stock over the past decade, it has two billion fewer shares outstanding, so earnings per share have quintupled.
There's more. Cisco has $46 billion in cash, compared with $16 billion in debt (that's net cash of about $6 per share). Cisco's net profit margin (earnings as a percentage of revenues) is a lovely 26%; P&G's is 16%, by contrast. Like many tech companies, Cisco does not have to plow big chunks of its profits into capital investment in new plants and equipment. And analysts on average project that Cisco's earnings will grow 8.4% annually over the next few years. That's not torrid, but it's more than the average large U.S. company. In short, Cisco is a growth stock that the market has priced as an extreme value stock.
So is Microsoft, the world's largest software maker, with a net profit margin of 30% and earnings expected to grow at the same 8.4% annual pace as Cisco. Microsoft's stock bottomed in 2002 at just below $21. Today, it trades at $28, up by about one-third. Yet profits have more than doubled. As for Intel, its price is up by about half, but its earnings have nearly tripled, and analysts predict that they will rise 12.3% annually over the next few years.
The problem with my analysis, you might say, is that it's nothing new. Tech stocks have been cheap for a long time and seem to get cheaper by the day as their P/Es contract. It seems investors don't believe the growth projections, as modest as they are.
Certainly, there's reason to worry. In a report to clients, analyst Steven Milunovich, of UBS Securities, points out that of the 15 biggest tech stocks in 1990, only one, International Business Machines (IBM), is still in the top 15 today. And IBM could just as easily have slid into oblivion without a brilliant rescue orchestrated by former CEO Lou Gerstner. Eastman Kodak ( EKDKQ ), the seventh-largest tech company in 1990, is now in bankruptcy reorganization. Nokia ( NOK ), the fifth-largest tech company as recently as 2000, with a market cap of $210 billion, now has a value of $13 billion. Shares of Advanced Micro Devices ( AMD ), once a hardy competitor to Intel, have plunged from $43 in early 2006 to $2.55 as profits have evaporated. At the end of 2000, even after a big skid in their share prices, Hewlett-Packard ( HPQ ), Yahoo ( YHOO ) and Dell ( DELL ) all had market caps greater than $100 billion. Today, their combined market value is less than $100 billion, and each is undergoing drastic restructuring.
So it's not coming up roses for all the tech giants. Milunovich, drawing from Nassim Nicholas Taleb's book Antifragile, argues that the sheer size of these companies makes them fragile--that is, subject to the stresses and volatility characteristic of innovation and shifting consumer tastes. But innovation and flexibility also render some big tech companies antifragile--that is, they thrive on change. Among the leading antifragile techs cited by Milunovich are Amazon.com ( AMZN ), Google ( GOOG ) and IBM. I like all three but would by no means consider their stocks cheap. Among the value giants, Milunovich says storage king EMC ( EMC ), trading at 13 times estimated 2013 earnings, and Apple, selling at 9 times estimated earnings, fall in the middle of the fragile-antifragile spectrum.
Winning By Changing
This formulation makes sense. Investors should look for tech companies that constantly reinvent themselves but offer a degree of protection with their strong brand names, such as Microsoft's Office software and Xbox video-game console. I disagree with Milunovich's judgment about Dell, which he sees as very fragile. In fact, Dell is a great example of a woefully undervalued big tech company, and if its bid to go private is successful, I expect it will prove the catalyst for higher P/Es for tech companies all around. Like Gerstner, Michael Dell may try to transform the company he founded by getting out of the low-profit PC business entirely and concentrating on networking and storage--or maybe on products we can't even imagine. It's not easy for a large company to engage in this kind of disruptive change. But it's more likely to happen at big tech outfits because they generate so much cash and because they have less to lose when they make a big change compared with, say, a retailer that decides to shift its focus from brick-and-mortar outlets to Internet sales.
I like Dell, but I'd wait to see how the buyout bid plays out before buying. And I'd avoid Intel because of the big bucks needed to build chip factories. Just focus on five of the behemoths I mentioned earlier: Apple, Cisco, EMC, Microsoft and Oracle. I can't tell you precisely which of their products will propel earnings for the next decade, and competitive threats will always loom. Just look at the huge gains South Korea's Samsung has made in just a few years (its shares don't trade on U.S. exchanges). But these five U.S. giants have proved they can innovate and defend, and they have loyal customers, loads of cash, solidly rising earnings, great global markets and absurdly low stock prices.
James K. Glassman is executive director of the George W. Bush Institute, in Dallas, whose latest book on economic policy is titled The 4% Solution. He owns none of the stocks mentioned.