Taking stock of tech
'Technology is the equivalent of heavy machinery for the new economy, and capital spending is always cyclical'

October 18, 2001

After a disastrous few months in which most stocks in the technology sector lost at least 70 per cent of their value, some investors continue to believe these stocks will bounce back to their prices of a year ago. Value managers, however, say this will never happen. In fact, they say tech stocks have even further to fall before their prices reach realistic levels. "We haven't had the final throwing in of the towel," says Irwin Michael, portfolio manager of ABC Funds in Toronto.

"Value managers usually set the bottom," says Kim Shannon, chief investment officer and senior vice-president of Merrill Lynch Investment Managers Canada Inc. in Toronto, "and we don't see value yet in tech stocks." Shannon says the technology bubble has even more hot air left to blow before tech stocks reach a level that reflects their true value. "In the past," she says, "manias have imploded by 70 to 90 per cent. Since March 2000, the Nasdaq has imploded by more than 70 per cent. I believe it will implode to 90 per cent before all is said and done."

As for the chance that tech stocks might rebound, value managers hold little hope for such a prospect. George Klar, vice-president of Toronto's Beutel, Goodman & Company Ltd., says tech stocks were grossly overvalued during the last few years. "Those mis-valuations should not occur again in our lifetime," he says. "That was a once-in-a-lifetime event."

Value managers point out that the prices of technology stocks are returning to their levels of six or seven years ago. "Many tech stocks can and should trade at underlying book value per share," says Bob Tattersall, president of Howson Tattersall Investment Counsel Limited and portfolio manager for Saxon Small Cap fund. "And many of them used to, including Nortel."

To trade at their underlying book value, the prices of tech stocks have had to plummet drastically. Nortel, for example, was trading last year at 110 times earnings. "Yet between 1983 and 2000, its average growth rate was 11 per cent a year," observes Andrew Sweeney, an equity analyst with Beutel, Goodman. Sweeney acknowledges that Nortel is a Canadian success story. "It went from $2.7 billion to $30 billion in revenues over that period. It's a solid company, and it has done well. But if, over the last 17 years, it has grown by only 11 per cent a year, how can you expect it to grow more rapidly? The bigger you get, the harder it is to find new business opportunities."

As the prices of tech stocks drop even further, they confirm what value managers have emphasized all along: technology is a cyclical industry. "Technology companies are capital goods companies," Sweeney says. "Technology is the equivalent of heavy machinery for the new economy, and capital spending is always cyclical." Even when their stocks are regarded as cyclical, technology companies don't make the best investment, Sweeney continues. "Technology has one of the lowest rates of survivorship of all industries."

That doesn't mean value managers won't buy a tech stock at all. "We've held tech stocks like Xerox and EarthLink," says Tim McElvaine, chief investment officer of The Cundill Group and lead manager of the Mackenzie Cundill Value Fund in Vancouver. "We sold them at a higher price, and they've come down again during the correction." Adds Michael: "My mandate is to find fundamentally undervalued stocks. If we can find a tech stock that's a value play, we'll buy it."