Events in the technology stock sector in the past couple of years have prompted no small degree of alarm among some market observers and pundits.
Their level of concern is so high that they’re using the b-word — yes, bubble. They say signs of a bubble include Facebook’s short-term share-price debacle after going public and the current performance of Twitter. Yet reports of a current tech bubble are greatly exaggerated.
The reality of the sector’s past and present can be viewed as a tale of two tech sectors — the 1990s bubble, which popped with public investor pain in 2000, and tech today. Once bitten and now shy, those who suffered pain in 2000 fear a repeat. But consider the differences between then and now.
The investor mania for tech companies in the 1990s was an amazing phenomenon. Seeking to profit from the market’s obsession with all things digital, venture capitalists pumped obscene amounts of cash into fledgling companies that went public with no revenue, and investors were only too happy to bid up the shares.
The poster child for these companies was Pets.com, which sold pet food and wares to the masses over the Internet. Never mind that shipping costs on your Great Dane’s 100-pound bag of chow would erase discounts, and that people tend to buy dog food in a rush when Fido’s larder runs out. Ten months after its IPO, Pets.com was out of business. The company had been buoyed above reality by credulous investors at a time when the market was going gaga over just about any company with dot-com in its name.
Today, tech companies have something Pets.com and its ilk didn’t: real sales. How much do you have to pay for a company’s sales? The best yardstick for measuring this is the price-to-sales ratio (P/S)—the price per share over sales per share during the last 12 months. The lower a company’s P/S, the higher its sales are relative to its price. This metric is superior to price/earnings ratio because, unlike the P/E, it can’t be manipulated with creative accounting.
Qualcomm, Apple and Intel are tech workhorses with great sales. These are tech companies that new ones should be generally judged against. Apple and Intel have a P/S of about 3, and Qualcomm, whose chips you’re probably using 20 times a day, has a P/S of about 5.
Twitter’s P/S is 28 (it topped 50 in February), which has prompted some to jump to the conclusion that Twitter is evidence of a bubble. Relative to many other tech companies, Twitter is expensive, but it’s hardly bubbleseque.
A bubble is when investors consistently over-pay in anticipation of continued price growth that isn’t justified by financial fundamentals and likely market demand for products. Twitter’s sales are increasing and show every sign of continuing to grow. Investors’ confidence that this will happen is priced into the stock.
Whatever price you’re paying for sales, if you’re paying a lot, a company’s sales had better be on an upward trajectory. When you see this growth dip, you want to be nimble and get out quickly.
The bubble worriers also obsess over Facebook’s rocky IPO. Just before Facebook went public with shares priced in the $30-plus range, critics questioned how the company would make money. These skeptics believed that the market was catching up to their view when the share price tanked down to the teens. But the company’s shares are now trading above $60, even though its P/S is about 19, because the market sees continuing sales.
Further fueling the bubblenoia is Facebook’s purchase of WhatsApp, the proprietary, cross-platform instant messaging subscription service, for a whopping $19 billion. Yet, the jury’s still out on whether Facebook, a company that’s all about personal communication, overpaid to corner the market on the hottest messaging technology. And besides, Facebook had the cash – unlike 90s tech companies that went into debt with little revenue.
The thing to remember about tech companies is that they play by different rules than companies in other sectors. The best among them consistently come up with products that consumers or businesses didn’t want or need before they existed. Thus, these companies create new markets purely from innovation. Think about this the next time you pull out your iPhone to check your email or view the Web on your television screen.
By contrast, consumer staples firms like Procter & Gamble can’t create their own markets. P&G’s P/S ratio is about 3, but for the company to sell more tooth paste, there must be more population.
Because some tech companies play by different rules, they should be evaluated differently. This is also true of some companies that we might not think of as tech stocks now but would have in the 1990s. A prime example is Amazon, which has turned the ’90s promise of Internet sales into a gangbusters reality. Though the company’s P/S is only about 2, its earnings are negligible — but for the right reasons. Amazon focuses on keeping product prices low and on relentless reinvestment, pouring money into thing like distribution centers and Kindle Fire updates. Amazon’s strategy is to first rule the world and then turn on the earnings spigot. The market likes Amazon’s brisk sales and intrepid development, so it forgives the relative lack of earnings.
Of course, just because there’s no tech bubble these days, this doesn’t mean that some tech companies aren’t over-valued. Tesla Motors and Netflix seem pricey, as do Angie’s List and Yelp. SolarCity, which manufactures solar energy gear, is trading at 25 times sales (a P/S of 25). It has sales of only $197 million against a market capitalization of $5.8 billion. One reason for its price is a federal tax breaks, but this could change with the next presidential administration.
The government’s largess toward Tesla, the electric car manufacturer (which also gets various clean-tech tax breaks) also could end, so it may be over-priced. Yet this hardly amounts to irrational exuberance toward the entire sector.
Tech stocks are the largest sector in the S&P 500 Index, at 19 percent. But unlike real portfolios, the S&P 500 doesn’t weight stocks — it just includes them in the index. To the extent that you can choose the right tech stocks (consistently innovative companies with sales that continue to rise) and weight them wisely, you might want more than 19 percent of the companies in your portfolio to be tech firms.
This way, you’ll be positioned to reap earnings from sales of products that don’t yet exist.
Dave Sheaff Gilreath is a founding principal of Sheaff Brock Investment Advisors LLC. He has more than 30 years of experience in the financial services industry, beginning with Bache Halsey Stuart Shields and later Morgan Stanley/Dean Witter. At Sheaff Brock, he shares responsibility for setting investment policy, asset allocation and security selection for the company's managed accounts. He also consults with the clients on portfolio construction. Gilreath received his Certified Financial Planner® (CFP) designation in 1984. He attended Miami University in Oxford, Ohio, where he earned a B.S. degree.
Any opinions expressed are solely those of the author and not of ABC News.