Tech Investing: The Myth of "Priced In"

To those who don't have to be actively involved in the stock market on a day-to-day basis, don't be. Honestly, the volatility and uncertainty in the market right now is making the most astute investors look like rank amateurs. In that kind of environment, unless you're a professional, focus on the task at hand; whatever that may be.

Now for the rest of us who have a fiduciary responsibility to be actively engaged in the market, let's talk about expectations. In an ideal world, a company's stock price would reflect the net present value of all future cash flows [adjusted for what portion of the total ownership of the company said equity represents, of course]. But in a world where companies are revalued on a tick by tick basis, a LOT of other factors can drive stock price movement in the near-, intermediate- and, yes, long-term.

As much as it pains me to look back on the bursting of the Nasdaq Bubble, the experience of being a technology investor in those years has served to steel me (somewhat) from the nastiness that's currently unfolding.

I keep hearing about how "this time it's different." In many ways, that's true:

• Valuations didn't start out at obscene, bubble levels
• The current market hasn't been littered with technology IPOs
• A much larger percentage of IT spending is maintenance related versus discretionary
• The rate of growth for overall IT spending isn't several factors faster than GDP this time out
• Technology, as a sector, isn't far and away the most crowded long trade

Acknowledging that the current environment for technology issues isn't the same as 2001 is comforting in terms of magnitude, but not necessarily in terms of direction.

As sell-side analysts slash and burn their forward estimates and lower their ratings on technology stocks, at a time when the market is already in a free fall, I've begun to hear from a lot of intelligent people that THE BAD NEWS IS PRICED IN.

Sounds great in theory, but falls short of today's reality...

• SAP AG (SAP) was down $5.97 today (13.08%) after issuing disappointing Q3 top-line results and characterizing the September shortfall as "sudden" and "unexpected"
• Double-Take Software (DBTK) was down $1.51 today (17.3%) after the company issued preliminary Q3 results this morning. This was a company that was already trading near its 52-week low and significantly below its 52-week high of $26.54
• RightNow (RNOW) fell $1.43 (12.9%) today after announcing negative CFFO due to extended payment terms and longer collection cycles. This was a company already trading far off its summer high of $17.26

These are just examples from today, to say nothing of the bloodbath we've seen in bellwether names like Research in Motion (RIMM) following an earnings report that didn't meet investor expectations.

The truth is, at some point the bad news will be "priced in" but we're not there yet (in my opinion).

Here are things I'll be looking for in the coming weeks as the earnings season unfolds:

1. Guidance meets reality -- Technology companies need to acknowledge the weakening economic climate and readjust expectations, both internally and in terms of published guidance to the investment community. The truth is, too few technology companies have lowered forward estimates yet, and as long as the velocity of earnings revisions is downward, stocks will struggle to find bottoms regardless of valuation
2. Cost rationalization -- Tech companies, even large, mature ones, have "growth" built into their DNA and often continue hiring aggressively in the face of slowing macro trends. I'm looking for evidence that the industry is slowing hiring and or making appropriate layoffs to right size their businesses
3. Putting money where their mouths are -- While semiconductor companies are capital intensive, many technology issues (software, internet, some hardware) are both cash flow positive and flush with cash on the balance sheets. With the SEC softening corporate buyback rules, and the market selling off demonstrably, there's no better arbiter of a "floor" in the industry than seeing cash-rich companies putting money where their mouths are. In a similar vein, I have a hard time accepting that stocks are bargains when company executives continue to sell their shares indiscriminately
4. Follow buy-side sentiment indicators, not sell-side -- Sell-siders aren't great market timers. And that's being kind. I don't look at a rash of downgrades in a bear market (or upgrades in a bull market) as predictive. But I do look at what my fellow buy-siders are doing in aggregate. If the HF industry is, in aggregate, overweight technology, in a declining market, the bad news isn't "priced in."
5. A stabilizing macro environment -- When the macro environment stabilizes, normalcy will return to tech spending soon enough. Areas where spending is largely non-discretionary (i.e., security, storage) should show the first signs of normalization, if history is any indication.

The market is a humbling mechanism. Yes, stocks aren't trading anywhere near the valuations they were during the Bubble. But let's not forget that many of those same companies ended up trading BELOW NET CASH at the bottom. I'm not suggesting we'll see those kinds of lows again this cycle, but understand that valuation isn't the only thing that matters. When aggregate estimates are going lower, it's VERY difficult for technology stocks to move higher. Impossible? No. But difficult? Indeed.

The key? Own great companies at great prices. Easier said than done? Perhaps; but that gets back to my original advice. To those who don't have to be actively involved in the stock market on a day-to-day basis, don't be.

Disclaimer: At the time of writing, neither the author nor the firms affiliated with the author maintained an position, long or short, in the publicly traded companies mentioned or any related instruments. The author and the firm reserve the right to alter their investment positions at any time in the future. The content on this site is provided as general information only and should not be taken as investment advice. Content should not serve in any way as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of firms affiliated with the author. Any action taken as a result of information or analysis on this blog is ultimately your responsibility. Consult your investment adviser before making any investment decisions. 

Comments

[Jason Wood]

Kris, nice to hear from you. Glad we see eye to eye on this. Keep up the good work by the way.

Jason

[Kris Tuttle]

I think your post is pretty much on the money. We are doing some analysis right now and it's pretty clear that estimates in general for Q4 and 2009 are not yet adjusted to fit reality. That certainly has to happen and hopefully will be what everyone does off the Q3 reports. (why wait? but that's another sad story...)

You bring up a key issue which is how the companies will control expenses. As you know a small reduction in revenue often leads to big changes in earnings.

Of course with everyone holding down expenses it fuels the cycle of shrinkage but we'll have to see how it goes. Good advice for now: stay on the sidelines and let it all play out.