Tech Stocks After The Fall - Interview

Kiplinger's Personal Finance Magazine, June, 2000 by Fred W. Frailey

INSIDER INTERVIEW | There's lots of life left in the new-economy stocks, says JEFFREY APPLEGATE.

INVESTORS TOOK technology stocks behind the barn and whacked them soundly this spring. Most commentators said it was about time they got whipped. Barton Biggs of Morgan Stanley Dean Witter calls Nasdaq stocks "a giant Ponzi scheme" and "a protruding nail that will be hammered." Christine Callies of Credit Suisse First Boston predicts years will pass before the absurd prices of tech stocks are wrung out. Bear Stearns' Elizabeth Mackey isn't looking for a tech resurgence anytime soon. Seemingly alone among Wall Street seers, Jeffrey Applegate says nothing has changed--that forces that propelled leading technology stocks in years past will keep right on propelling them when this dustup settles.

Perhaps you've never heard of Applegate, the Lehman Brothers investment strategist who largely advises institutional and wealthy individual clients. But if anyone qualifies as a cheerleader for and explainer of the forces of the new economy, it is the handsome and affable Applegate. His enthusiasm for this sector is such that he recently created Lehman's "virtual economy portfolio"--34 stocks that he thinks constitute the best of the wired and wireless world. (See the list.)

So when the technology stocks got driven down about 30% in April, and I-told-you-sos erupted from those who had predicted this and more would happen to the overvalued sector, a visit with Applegate seemed in order. We caught up with him at Lehman's office at the foot of Manhattan, and got right to the point.

KIPLINGER'S: Have technology stocks run out of steam?

APPLEGATE: Not at all. These are the growth stocks of our era--it's that simple.

How can you say that, after the licking these stocks have taken? What you've seen is a very typical market move. First, tech stocks shot up from undervalued to overvalued. And before they stabilize they will probably be undervalued, given that the stock market typically spends a nanosecond at fair value. We've seen this happen time and again since tech stocks started doing so well, in 1993. Think of what happened in April 1999. You had a move in old-economy stocks that lasted six trading days, while tech stocks got creamed. We will go through these spells repeatedly because the virtual economy has barely begun.

Which stocks got hurt the most this time? The ones with flawed business plans. These are mainly Internet companies that cater to consumers. I would have been amazed had they continued to levitate. Now their shareholder equity is evaporating. If Cybershops and Drkoops and Value Americas don't get taken over or obtain a cash infusion, they're probably not going to be around.

Still, what is it that leads you to believe that the better tech and Internet stocks will roar back? Several things. Because of technology, we are witnessing the most sustained deflation in capital-goods prices since we began collecting data, on the order of 3% per year. At the same time, the cost of labor is rising about 3 1/2% per year, making it extremely attractive for companies to substitute capital for labor, using technology. As those costs continue to deviate from one another, the difference will encourage even more purchases of capital goods, heavily weighted in technology.

Do lower prices have something to do with Moore's Law, which is that the power of semiconductors doubles every 18 months while the cost is cut in half? Yes. The big debate in techland is whether Moore's Law is now accelerating. On top of that, you've got the impact of the Internet, which is causing a seismic shift in the organization of economic activity. The Internet is the most deflationary event of our lifetime.

Why is this so? The Internet shrinks time and space and makes things more efficient. That was what the railroads did in the 19th century, and prices came down enormously. It is what drives all the business-to-business initiatives via the Internet. Lawrence Bossidy of Honeywell said that if his company purchases something in the real economy and it costs $10.50, in the virtual economy it would cost 50 cents. You hear examples like this on almost a daily basis.

So if the tech stocks have staying power, how much do they have? Nothing lasts forever, right? How long did the Industrial Revolution last? A long, long time. What's different about this is that it's much bigger and it's much faster

and it's much more global, which the Industrial Revolution never was.

Don't price-earnings ratios exceeding 100--or the infinite P/Es of unprofitable tech companies--preclude sizable price gains for the foreseeable future? Look at Cisco Systems, with a P/E of 100. I'd argue that there wasn't much margin for error at, say, Procter & Gamble at a much lower P/E. One-third of its share price went away in a day on some bad news. To me, just because the P/E is rich doesn't mean you've got a risky stock.

Risk is directly related to how well or how poorly the business is being run. You mentioned Cisco. It buys another company about every other week and gets most of those acquisitions right. It has developed a global distribution system, and over the past eight or nine years the company has accelerated its earnings-growth rate and made it more stable at the same time. Well, that's pretty interesting. Cisco should be afforded a higher P/E ratio. Its earnings are growing at a 30% rate--three times that of the overall market. If the P/E of the overall market is 22, how wildly out of whack is Cisco at 100? Not much.