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Tech stock update
A valuation check up

At one time, the topic of technology stocks was a regular one in this space. So many people were invested in the volatile sector that it deserved lots of attention as uncertainties started to surface. After a hiatus from discussing tech stocks, this week's article revisits the popular sector, their valuations, and what the future might hold for today's buyers.

Previous views on tech stocks

Some of the information in this old, May 2000 article is dated, but it's the first time I warned publicly of the high valuations in tech stocks. After that article appeared, I wrote five separate articles in this space, from September 2000 through March 2001, warning of high valuations among tech stocks.

By October 2001, 9-11 had happened and stocks were crushed. My advice at that time was, from that article:

"I'm still a little leery about technology. Now, I'd say this is probably a decent time to start building a position very slowly for those who are bullish on technology longer term. Everybody hates technology right now. With lots of economic stimuli at work, I'd be willing to go out on a limb and say that tech stocks may start to produce respectable returns at some point next year or two, but lots of patience (and a strong stomach) is required."

But then in early 2002, tech stocks had run up so briskly that I advised taking some money off the table. Then, last fall I reasoned that it made more sense at that time to get technology exposure through venture capital, or labour sponsored funds. My recommendations have been as volatile as the Nasdaq.

Having come off another strong run since the fall, many people are again tempted by the lure of high returns and how bright the future might be.

Valuation

A discussion of future potential is incomplete without first addressing the price paid today - i.e. current valuations. There are currently more than 3,600 stocks traded on the Nasdaq - the top 25 of which account for nearly 45 percent of the Nasdaq's total market value. Here is a weighted average valuation summary for the largest 25 stocks trading on the Nasdaq:

- Price-to-Sales (P/S): 6x
- Price-to-Earnings (P/E): 34x
- Percentage of firms that reported a loss: 24 percent

Recall that stock valuations represent the market's expectation of the future. Admittedly, the market doesn't seem to peek too far into the future. The valuation figures noted just above have some pretty high expectations built into them.

For the purposes of the illustration that follows, suppose the Nasdaq market is a single stock with the valuation characteristics noted above. Let's also suppose that investors expected to earn a compounded rate of return equal to 10 percent per year. This hypothetical stock, trading at 34 times last year' s earnings, would have to grow its bottom line profits by a full 11 percent per year for the next ten years - without missing a beat.

To put this into perspective, let's make some assumption about what U.S. inflation will be going forward. Over the past seventy-seven, it's been in the 3 percent per year range. Let's use that historical average. During that same period, corporate profits have grown an average of 1.5 percent above inflation.

To further put the historical profit growth into perspective, the 1990s was the decade with the highest "real" (i.e. net of inflation) U.S. profit growth of any decade starting after 1929. During that ten-year period, corporate profits (as measured by S&P 500 profits) grew at a rate of nearly 5 percent above inflation.

Even if we repeat that decade, with 3 percent inflation, total earnings growth will be 8 percent annually. I estimate that would translate into a rate of return of about 8.5 percent per year. But, we're not likely to repeat (or exceed) the biggest growth decade in U.S. history. Going back to the historical average of 1.5 percent annual profit growth (net of inflation) translates into investment returns of about 6 percent per year. Given the extreme volatility of the Nasdaq, there's a good chance that most people wouldn't actually earn that much.

In other words, I don't expect that today's buyers of tech stocks will be well rewarded for the risk they're assuming.

Investors and advisors must pay great attention to what you're buying and make sure expectations can stand up to scrutiny. Otherwise, be prepared for disappointment.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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