Time For Conservative Investors To Look At Tech Stocks

by: Tim McAleenan Jr.

If you’re anything like me, you consider yourself a proud adoptee of the Warren Buffett philosophy when it comes to large-cap tech stocks. That is, you’re skeptical of claims that tech stocks have strong economic moats — you have no idea what large-cap tech will look like in ten years, and you know all too well that technological obsolescence can bring even the mightiest of corporations to their knees. Sure, you see the daily headlines about Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Intel (NASDAQ:INTC), IBM (NYSE:IBM), and Microsoft (NASDAQ:MSFT) blaring across financial websites and TV stations, but you simply smile, nod, and count your Coca-Cola dividends as you politely decline the pitch from both your broker and your friends to load up on shares of the tech giants.

After all, you remind yourself, Apple was a sputtering, milquetoast corporation fifteen years ago — back then, it surely wasn’t a company with more cash on hand than the US government. Steve Jobs wasn’t a national hero with a cult following, he was a man who just got fired from the company that he founded. And back then, Google was a pipe dream, not a word that you use as a verb for looking something up online. Intel, IBM, and Microsoft were markedly more established fifteen years ago, but conservative investors still were suspicious of how quickly technological fads could wreak havoc on shareholder equity. Go ahead and ask former Blockbuster shareholders how much fun it is to reinvest dividends when the shares you’re reinvesting into are about to become glorified wallpaper.

First of all, most conservative (and certainly retirement-focused) investors shy away from stocks that don’t pay dividends. A lot of times, this makes sense — you can’t fake cash flow, dividends force management to act with more discipline since it weakens the ‘money-burning-hole-in-pocket’ syndrome, and high dividend-paying companies have a lower likelihood of doing things like, say, paying $8.5 billion to buy Skype.

But let’s take a look at the numbers.

Google has seemingly built a strong moat over the past the decade. I don’t think anyone is betting on the return of Ask Jeeves to knock Google off its high horse. Google earned$16.69 per share in 2008, $20.41 per share in 2009, and $26.31 per share in 2010. And they’ve earned $14.72 per share so far in 2011 (and typically, Google has shown sharp increases in the third and fourth quarter. From 2008 to 2010, Google increased earnings by 57.6%, or 28.5%. If you look at Google’s trailing 12-month earnings of $27.72 per share, and assume 18% annual growth over the next five years, Google will be earning $67.73 per share annually. Right now, it’s P/E ratio is 18.71. If it has the same price-to-earnings ratio in five years, the shares would be trading at $1,267.23. That would enable you to double your money and then some.

Apple’s gotten a lot of attention recently with reports that it has more cash (and marketable securities) on hand than the US government. Warren Buffett famously warned investors to be fearful when other investors are greedy. And everyone seems to be bullish on Apple these days. BUT, the main reason why Apple investors think the stock has a lot of room to run is because it’s only trading at 14.79x earnings. That seems to be an absurdly low valuation. For comparison, Proctor & Gamble (NYSE:PG), the stodgy blue chip, is trading hands at 16.04x earnings. Apple has grown earnings by 30% annualized over the past ten years, and 70% annualized the last five. If they can grow earnings by 20% for the next five years, Apple will increase yearly earnings from $25.26 to $68.10. If Apple were to trade at 16x earnings in five years assuming 20% growth, it should be trading at $1,089.60, compared to its price today of slightly over $373.

Intel shares seem to be noticeably beaten down. Trading at only 9.03x earnings, Intel offers potential investors an 11% earnings yield. Intel has earned $2.18 per share over the past twelve months, and it’s only paying out $0.84 per share in dividends. Over the past five years, Intel has seen its dividends grow by 25.5% per year. Let’s say Intel only manages to grow its dividends by 12% per year for the next five years. That means Intel would be paying out $1.48 per share in dividends. So if you can get in now at $19.70 per share, you’d be earning an effective dividend yield of 7.5% within five years. That may not be a bad bet to make.

IBM, like Intel, has been raising its dividend at a very impressive rate these past five years. In 2006, IBM paid out $1.10 per share in dividends. IBM paid out $2.50 per share in 2010, and will most like pay out $2.89 per share this year. But with shares trading at $164, IBM only offers investors a yield of 1.8%. According to IBM’s five-year roadmap, they will be earning $20 per share in 2015. For what it’s worth, IBM reached its earnings goals for the 2006-2010 stretch about a year early. Right now, IBM trades at a P/E ratio of 13.39. If we project that IBM will reach its $20 per share goal by 2015, and trade at the same P/E as it does now, its shares would hit $267. Additionally, this may be on the conservative side of estimates since IBM has gotten in the habit of hitting its earnings objectives early to impress analysts, and it’s P/E has compressed a bit during the recent pullback.

Microsoft might be the black sheep of the family of companies that we’re looking at today. The stock price has languished for quite a while, and you can pick up on the disdain in the voices of MSFT investors whenever they mention, “CEO Steve Ballmer.” The problem with Microsoft stock is that it has been overvalued for at least the past five years. Microsoft has grown earnings by 11% per year since 2006, and the dividends have grown by 21.5% per year, from $0.34 per share in 2006 to $0.64 today. Microsoft is trading at less than 10x earnings, which seems incredibly cheap. At today’s price of $24.72, you could buy into Microsoft at a 10.9% earnings yield. If you think that Microsoft will grow at an annual rate greater than 10%, you should do quite well if you’re already buying in at an earnings yield greater than 10%.

I’m not necessarily advocating that conservative investors should jump into tech stocks. I would say that Proctor & Gamble’s future strikes me as much more predictable than Microsoft’s. But, if a conservative investor has the itch to put 10-15% of his portfolio into large-cap tech, today’s prices probably aren’t a bad time to take the plunge.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.