In With the ‘New,’ In With the ‘Old’
The investment story of the new millennium has been a consistent pattern of soaring tech stocks and collapsing industrials, prompting much speculation about a fundamental “old economy/new economy” divide. But the old/new stock-market buzz is mostly flapdoodle and says more about the grasshopper memories of stock-market professionals than about economic realities. The recent bounce back in the Dow and sudden jitters in the techs suggest just how shallow the old/new analytic really is.
The debate was triggered by a steady drop in the Dow Jones industrial average, a sort of hall of fame for old-economy stocks, which is down about 7% since its January high. The bellwether consumer stock, Procter & Gamble, was pummeled when the company predicted lower earnings than analysts expected, prompting violent fluttering in Wall Street’s dovecotes. Meanwhile, the heavily tech-weighted Nasdaq composite keeps right on breaking records, racking up annual gains in the 100% range even with the declines of last week.
Confusion is compounded by some very complicated economic realities. High-tech companies are transforming U.S. business and have been a major factor in the stunning productivity advances of recent years. But, at the same time, probably most high-tech stocks, particularly Internet stocks, are ridiculously overvalued. Yes, the Dow as fallen hard in 2000, but that’s only after five years of extremely strong share-price increases. With some exceptions, most Dow stocks still have very healthy valuations.
First the Dow. Even with the recent drop, Dow stocks have turned in 20% annual gains for five consecutive years, an extraordinary performance. The traditional way of valuing a stock is to multiply share price and total shares outstanding, then divide by earnings, which gives you the price-earnings ratio, or PE. A decade or so ago, a PE of 10 or 12 was considered normal for a healthy company, and eyebrows rose when PEs crept over 15 or 16. Markets got nervous when PEs shot past 20 during the 1980s buyout boom. Now, the average PE of a New York Stock Exchange stock, which includes relatively few of the tech highfliers, is more than 30.
The PE of General Electric, for instance, the biggest of the old-economy stocks, exceeds 40; Exxon Mobil is at 36; Wal-Mart at 39; and sleepy, confused AT&T; at about 30. Even Procter & Gamble ended last week with a PE of 22. There has been, in short, no flight from the Dow. After five years of extraordinary growth, old-economy stocks mostly still have very high valuations. Perhaps it’s time the market sat on its hands for a while and let earnings catch up to extremely high share prices.
The tech story is more complicated. The Internet is having an extraordinary impact on business practices, creating stunning efficiencies in purchasing and customer relations. Every major company in the country is in the process of rebuilding its internal systems to take advantage of the opportunity.
These are golden times for the companies that make the hardware and software that run the Internet, so the high prices of stocks like Microsoft (PE over 60), Cisco Systems (PE of 191) and Oracle (PE of 178) may not be crazy. Extraordinary opportunities justify extraordinary multiples.
But the dot-com stocks are a different story. Consider the Goldman Sachs Internet Index, a composite of 17 highflying Internet stocks that have racked up a cool 800% price gain over the past year and a half. Of the 17 companies in the index, only six make any profits. Just one company, America Online, accounts for more than 80% of the profits of the entire group, but AOL has always been more of a media company, and by Internet standards, one that’s never been a technological leader. The other company that has substantial profits is CMGI. CMGI is a holding company that owns dozens of Internet start-ups, which collectively lose rivers of money. Why is the company profitable? Because last year, it made almost a billion dollars selling the stock of its money-losing companies to the public. Specialists, that is, in the art of blowing bubbles.
A handful of other companies in the index eke out minuscule profits and trade at absurd PEs, ranging from about 1,800 for Yahoo! (a Web portal) and EBay (a Web auction company) to 8,000 for VeriSign (software to allow signatures over the Web). The remaining 11 companies all lose money, so their stock prices, as Securities and Exchange Commission Chairman Arthur Levitt recently put it, is 1,000 times nothing.
What drives the Internet valuations? Part of it is simply frenzy that feeds on itself. Astonishing gains pull the naive investor out of the woodwork. Frenzied buying fuels more gains, driving more buying, until some event breaks the psychology. That’s the definition of a market bubble, whether it’s tulips, Tokyo real estate or whatever.com.
In the case of the dot-com stocks, prices are also driven by scarcity. Most recent public offerings of tech stocks have sold only a relatively small number of shares to keep valuations high. (If you sell 10% of your company for $100 million, you company has a market value of $1 billion.) When there is a demand for a stock because the sector is hot, but relatively few shares are available, they change hands quickly, sometimes several times a day, and prices go through the sky. Quite possibly, the valuation would be far lower if 30%-40% of the shares had been put on the market, because there wouldn’t be such a scarcity premium.
Many countries require that initial public offerings float a minimum percentage of the company, usually about 30%, precisely so valuations will reflect reasonable supply and demand. The United States does not have such a rule, so limiting share availability is a standard ploy to keep values high.
At the end of the day, fundamentals do matter. The fundamentals say that the Dow is still high, to the point where it is silly to talk about a flight from the old economy. Fundamentals also say that selected technology stocks may justify unusually high values. And they say that we are experiencing a dot-com bubble that will pop in due course, leaving the naive and greedy in tears.
