Seeking Alpha contributor Jacob Steinberg says it's 1999 all over again, and the tech bubble is back. From couponer Groupon (GRPN) to internet radio company Pandora (P) to social media like LinkedIn (LNKD), Facebook (FB), and Zynga (ZNGA), and even mega-e-tailer Amazon (AMZN), tech stocks with sparse earnings are commanding sky-high valuations. In the past few years, Amazon's P/E has skyrocketed from 50 to 185 despite lackluster earnings.
Investing in companies that haven't shown the capacity to translate traffic into earnings is obviously a risky play.
Ugly Duckling Stocks: Reasons to Love Old Tech
The problem with highly-touted "new tech" stocks like the ones listed above is that they have a very high bar. In March, for example, Groupon was trading at a higher valuation by market cap than Alcoa (AA) -- even though they hadn't yet seen a single profitable quarter.
Investors should be cautious of stocks with high levels of earnings growth priced in already, because this leads to a skewed risk/reward profile. With stocks priced so highly, much of the upside is already built in -- and worse, "good growth" isn't enough to sustain the high multiples over time. If the companies don't deliver phenomenal returns, investors can expect flat returns at best.
Yet despite the ridiculous valuations commanded by new tech, there's still a lot of value to be found in tech. As explained by Donald Yacktman, money manager and value investor extraordinaire:
If someone told me 10 years ago that two of our top 10 holdings would be Microsoft and Cisco, I would have laughed. These were different companies back then. They were very expensive and today they are relatively cheap and profitable. Jason, a co-portfolio manager, put it well. He said, "It is almost always about the stock price."
Looking just at price charts, it's easy to see why "old tech" has fallen out of favor with investors. I'll use Intel (INTC), Microsoft (MSFT), and Cisco (CSCO) as representative samples of old tech. Stock performance over the last decade has been downright uninspiring.
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The reason for lackluster performance is the phenomenon I explained above, when I stated that high-P/E "growth" stocks have almost all the upside priced in. Over the past decade, the "old tech" stocks underwent significant P/E compression, falling from well over 40 to a more reasonable 10-15 range. Stock prices remained flat because all that growth was already priced in -- thus, even as earnings rose, the stock stayed flat as P/E declined sharply. (It's worth noting that "old tech" stocks used to be "new tech" stocks. So essentially, Zynga et al are where Microsoft and Cisco were 10-12 years ago.)
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INTC PE Ratio data by YCharts
EPS tells a completely different story than the stock price. While companies like Facebook have been struggling to monetize their userbase, the old tech companies have quietly logged steady growth.
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MSFT Earnings Per Share TTM data by YCharts
These companies also generate strong free cash flow.
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MSFT Free Cash Flow TTM data by YCharts
Finally, these companies have rock-solid balance sheets, including substantial cash holdings.
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MSFT Cash and Equivalents data by YCharts
Conclusion
It's easy to forget that Microsoft, Cisco, and Intel were all considered "hot growth stocks" in the late '90s, and investors were rushing to jump on the bandwagon despite sky-high P/Es. Yet as the charts show, the stocks underperformed over time despite strong growth. (MSFT's EPS went from $0.68 in 2001 to over $2.75 currently -- 13.5% annual EPS growth). Why? Because they were priced too high to begin with. The exorbitant P/E ratios left no room for the share price to grow.
P/E compression and flat share price isn't actually the "worst case" scenario for investing in the Hot New Tech Thing -- thousands of companies closed their doors after the collapse of the dot com bubble. So why are investors still rushing into new tech and social media stocks despite all these problems? I don't know. But I do know that history has generally been unkind to stocks that put the cart (share price) before the horse (earnings).
With so much value available in out-of-favor "old tech" stocks that actually have earnings, cash flow, and strong balance sheets, the risk/reward ratio is clearly not in favor of new tech stocks. Over the long term, statistics show that "value" stocks outperform "growth" stocks. Right now, there's just no reason to invest in companies with unproven-at-best earning ability given their relative price to companies that actually generate FCF.
So hang on to your convictions, even if all your friends jump on the Social Media Train. In the long term, your portfolio will thank you.
Disclosure: I am long CSCO, INTC, MSFT.
Additional disclosure: I hold a direct position in INTC. I have a "long" position in CSCO through writing of CSCO put options. I am long both CSCO and MSFT via the Yacktman Focused Fund (YAFFX).
