Tech’s Turnaround Brings Note of Caution

Shares of computer networking giant Cisco Systems Inc. rocketed 85% last year, and by Dec. 31 had reached their highest level since early in 2001.

Investors who figured that the turn of the calendar might stop the ascent instead have seen Cisco’s rally accelerate: The stock has gone up an average of 1.6% a day so far in 2004, hitting $27.03 on Monday.

Cisco’s continuing advance is one reason the Nasdaq composite stock index is soaring again this year. The index Monday jumped 24.86 points, or 1.2%, to 2,111.78, a 2 1/2-year high. It has risen 5.4% since the new year began, compared with the blue-chip Dow Jones industrial average’s mere 0.3% rise.

But the resilience of technology stocks, including many of California’s biggest names in the industry, is worrying some Wall Street pros who fear that the sector is being driven largely by “momentum” players -- the same kind of bandwagon-jumping investors who helped fuel the Nasdaq bubble of 1999 by simply buying what was going up.

Just as that wild rally ended badly, so, some say, will this one.

Others say that while there is froth in Nasdaq, it isn’t approaching the level of the last market peak. Investors who remain bullish on the tech sector say the stocks, despite their gains, don’t yet fully reflect the earnings rebound the industry will see in the next few years.

“This is an industry that is going to have above-average growth,” said Daniel W. Boone III, managing partner at Atlanta Capital Management in Atlanta. He believes that Wall Street is still in the “sweet spot” of recognizing the magnitude of tech’s turnaround.

The debate over what constitutes a fair price for a stock is never-ending, but it has taken on greater urgency in the tech sector as the shares have zoomed over the last year.

The Nasdaq composite index, dominated by stocks such as Cisco, Internet portal Yahoo Inc. and computer chip maker Intel Corp., rose 50% in 2003.

The Nasdaq index still is a shadow of its former self: It is down 58% from its record high of 5,048.62 reached in March 2000. That’s one reason Nasdaq market authorities are trying to boost their trading business by wooing New York Stock Exchange-listed companies to “dual list” their shares on Nasdaq as well as on the NYSE.

But major technology issues are likely to remain Nasdaq’s bread and butter for the foreseeable future. And as the stocks have climbed sharply over the last year, many on Wall Street have warned that investors are in danger of overpaying relative to the companies’ underlying earnings -- the great sin of 1999 and early 2000.

“Based purely on the fundamentals, tech is overvalued,” said Peter Dunay, chief market strategist at brokerage Wall Street Access in New York.

Cisco’s shares, at $27 each, sell for 39 times the 70 cents a share that analysts, on average, expect the company to earn in the fiscal year that ends in July.

That is about double the 2004 estimated price-to-earnings ratio of the average blue-chip stock, as measured by the Standard & Poor’s 500 index.

The price-to-earnings ratio is just one gauge to use in judging a stock’s appeal. But the general rule of thumb is that, the higher the P/E, the greater the risk to the price if bad news should hit.

Some non-tech Nasdaq stocks that boasted high P/Es in 2003 have suffered sharp declines as investors have grown less confident about 2004 earnings. One is upstart airline JetBlue Airways Corp. At its peak in October the stock reached nearly $47. That gave it a P/E of about 40 based on then-estimated 2004 earnings per share.

But investors have since soured on the company’s near-term prospects. By Monday JetBlue had slid to $24.44. Investors who paid the peak price in October have lost about 50%.

Market pros say JetBlue, at its highs, was a classic momentum stock: As the price climbed for much of 2003 it attracted more short-term investors who were merely looking to ride the uptrend as long as it lasted. Momentum players typically aren’t concerned with P/Es or other valuation measures.

Some experts say momentum buying has become the driving force behind the rise of many tech stocks. “If you’re an aggressive ‘day trader,’ tech is terrific now,” Dunay said. Longer-term investors, however, should steer clear, he argues.

Others say that although many investors may in part be playing the momentum game with technology, the demand for the stocks also reflects classic bull-market behavior of seeking shares in the most exciting growth industries.

Technology “obviously is where the action is” for momentum investors, said Peter Boockvar, equity strategist at Miller Tabak & Co. in New York.

At the same time, for many investors “the focus is on the direction of earnings rather than on the actual numbers,” he said. In other words, investors are willing again to pay above-average P/Es for tech because they have faith that profit growth also will be above average in coming years.

That’s the view of Boone at Atlanta Capital, which manages about $9 billion and holds shares in tech names such as Cisco, Intel, Dell Inc. and computer services firm CDW Corp.

Cisco’s earnings are expected to rise 19% in the current fiscal year and 16% in fiscal 2005, based on analysts’ average estimates as compiled by Thomson First Call in Boston. By contrast, operating earnings of the S&P; 500 companies are expected to rise about 13% this year.

“Tech is still one of the growth industries in our economy,” Boone said. “You will pay a premium for that. I don’t call Cisco speculative at a [P/E] of 30 to 40.”

Even so, he said, some tech stocks have reached levels that can’t be justified. Atlanta Capital sold all of its shares of computer systems firm Sun Microsystems Inc. in the fourth quarter as the stock rallied to $4.47 by year’s end, up 44% for the year, Boone said.

“Based on the fundamentals we didn’t want to hold it,” he said. Wall Street doesn’t expect Sun to return to profitability before 2005.

Boone and other market pros note that tech leaders’ P/Es for the most part are well below the 100-plus peaks of the last market boom in 1999 and 2000.

“Back then you were putting money into anything that was going up,” said Stephen Carl, who trades stocks at Williams Capital Group in New York. This time, he said, tech stocks are benefiting from some genuine “cautious optimism” about the economy, not just ill-informed momentum trading.

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Too expensive?

Here’s a look at the gains racked up by some major tech shares last year and this year, and the stocks’ price-to-earnings ratios based on analysts’ average estimates of 2004 earnings per share.

*--* Mon. % gain: % gain: Est. 2004% Company close 2003 2004 P/E * Cisco Systems $27.03 85.0% 11.6% 39 Qualcomm $60.09 48.2% 11.4% 39 Yahoo $49.74 175.4% 10.5% 92 Applied Materials $24.63 72.2% 9.8% 48 Veritas Software $39.87 137.0% 7.7% 43 Intel $34.15 105.8% 6.6% 28 Dell $35.57 27.1% 4.7% 29 Electronic Arts $48.96 91.6% 2.7% 25 Nextel Commun. $28.34 142.9% 1.0% 16 Microsoft $27.57 5.9% 0.7% 24

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* Based on estimated operating earnings per share for the current fiscal year or the fiscal year that covers the bulk of calendar 2004.

Sources: Thomson First Call, Bloomberg News