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October 16, 2000

Here Are Six Myths That Drove

The Boom in Technology Stocks

By E.S. BROWNING and GREG IP

Staff Reporters of THE WALL STREET JOURNAL

There's just about no limit to the earnings, sales and productivity gains technology companies can generate.

Tech companies aren't subject to ordinary economic forces, such as interest rates.

A tech company's prospects are more important than its earnings.

These were some of the guiding principles that millions of investors embraced as they created the historic surge in tech stocks that started in late 1998. The hottest stocks were pioneers of the young Internet. But they weren't the only highfliers buoyed by a widespread faith that a new set of rules applied to tech stocks.

Microsoft Corp. stock rose 16-fold between the end of 1994 and its high last year, powered by the belief that its software had secured a permanent monopoly. Dell Computer Corp. multiplied 93-fold between the same starting point and its peak this March, on the view that it could generate astonishing personal-computer sales growth no matter how big it became. Similar arguments drove up Intel Corp. 19-fold and Lucent Technologies Inc. 12-fold during roughly comparable periods.

These companies, and dozens of others, propelled the greatest bull market in history. The Dow Jones Industrial Average jumped 200% from the end of 1994 to its peak in January, and the tech-heavy Nasdaq Composite Index had leapt 571% when it reached its high in March.

"It's Not Tulip Mania," declared a report by Merrill Lynch & Co.'s chief economist, Bruce Steinberg, that attempted to justify the stratospheric gains of big tech companies. The report was published March 13, just after the Nasdaq Composite Index had hit a peak of 5048.62.

But suddenly all bets are off. The Dow is down 11% this year. The Nasdaq Composite Index is in the throes of a savage bear market. By late last week, it had collapsed almost 40% from its March high, before recovering almost 8% on Friday. Even after Friday's gain -- the second-biggest percentage jump ever for the Nasdaq -- the index remains 34% off of its high and deep in bear territory.

And look what's happened to the tech stars that led the markets up: Dell, down 54% from its peak this year. Microsoft down 55%. Intel down 47%. Lucent down 72%.

What's clear now is that many of investors' most cherished beliefs about technology stocks have come unraveled. Here are six of the most potent myths -- and the difficult truths that, in hindsight, they were masking.

Myth No. 1:

Tech companies can generate breathtaking gains in earnings, sales and productivity for years to come.

This was probably the most pervasive and influential of all tech-stock myths, partly because it seemed so hard to challenge. Growth in tech-company sales and earnings was undeniably outpacing growth elsewhere. This discrepancy was widely believed to make big New Economy companies different from big Old Economy companies, most of which typically achieve single percentage-point increases in annual sales.

In February, Jeffrey Warantz and John Manley of Citigroup Inc.'s Salomon Smith Barney unit published a report claiming that the huge gains in tech-stock prices were reasonable because "the growth in projected earnings has been equally impressive."

Technology's contribution to economic growth underpinned the analysis by Merrill's Mr. Steinberg in his Tulip report. In the late 1980s, he noted, earnings at big tech companies grew more slowly than at most other companies. By the late 1990s, tech earnings were growing twice as fast as those of other companies, which was a good reason to value tech stocks more highly.

The facts weren't wrong. But this view didn't take into account that the price of tech stocks had grown so fast that the stocks had become "priced for perfection," as the skeptics like to put it. Any false step and the stocks would plummet. Nor did this perspective on the market take into account a historic reality: No matter how good a company is, it can't maintain as a large organization the same growth rate it had when it was much smaller.

Dell, for example, boosted revenue by about 50% a year from 1996 through 1998. Skeptics said that a company selling a commodity like a personal computer just couldn't keep posting those kinds of gains year after year. Dell enthusiasts, whose numbers grew as the astounding results rolled in, maintained that its direct-sales model and use of the Internet would permit it to surprise skeptics for years to come.

Then, in 1999, sales growth slowed to 38% -- still enormous, the bulls enthused. But earnings growth also slowed, and in the fall of 1999, Dell warned investors that its earnings would fall short of estimates. The stock bounced around as bulls and bears fought it out over the company's growth prospects. But in the end, the skeptics were proved right. Dell warned repeatedly that its performance would disappoint. On Oct. 4, it said that this year's third-quarter revenue and fourth-quarter earnings would miss targets.

Myth No. 2:

Tech companies aren't subject to ordinary economic forces, such as a slower economy or rising interest rates.

Until the late-1990s, technology was considered a cyclical business, its sales and profits rising and falling with the overall economy. But as the tech craze shifted into high gear, one of the most popular arguments in favor of technology companies was that demand for their products was so enormous that it would keep growing through the peaks and troughs of the Old Economy.

Demand has remained strong, but not as strong as many more-optimistic investors had hoped. Personal-computer sales, for example, were thought to be able to grow regardless of general economic conditions, as they had through most of the 1990s, says Andrew Neff, an analyst at Bear Stearns Cos. As recently as early August, he told clients to expect a strong second half for PC sales, "driven by multiple factors," including the end of Y2K hangover, Microsoft's Windows 2000, a turn-up in Europe and the launch of Intel's Pentium 4 chip.

But then one PC-related company after another shocked investors with warnings of softening business, from Intel to Dell to Apple Computer Inc. Mr. Neff, who used to dismiss such warnings as "company specific," now says he has changed his thinking. "Demand problems are serious and difficult to quantify," he says. The PC business is now cyclical, he adds, and investors should sell PC stocks when the fundamentals begin to deteriorate.

In the same vein, rising interest rates were once thought bad for tech companies because they slowed the economy and made it costlier for customers to finance purchases of tech equipment. But as the Fed began raising rates last year and tech stocks, after a brief dip, kept rising, many analysts argued tech companies were immune to interest rates because demand for their products was so strong and their borrowing needs so slight.

As it turns out, even though tech companies don't borrow much themselves, their customers do. And as buyers have curtailed spending, tech suppliers have suffered. Lucent, for example, has warned investors that fiscal fourth-quarter profit would be hurt by reserves it is taking against bad loans extended to its customers.

Myth No. 3:

Monopolies create unbeatable advantages.

Some tech companies were thought to deserve extraordinary valuations because the nature of their products created near monopolies.

The huge number of people using Microsoft's operating-system software or America Online Inc.'s instant-messaging service gave those companies a critical mass of customers -- a network -- that made it hard for others to break in and compete.

"Networks offer the opportunity for explosive shareholder returns," Michael Mauboussin, Credit Suisse First Boston Corp.'s chief investment strategist, wrote in May. "Network effects played a prime role in Microsoft's ability to create $350 billion in market value over the past 15 years."

One problem with this argument is that government may become suspicious of monopoly power. The Justice Department's antitrust suit against Microsoft has helped cut its stock in half and reduce its market value to about $285 billion. Now, authorities are raising questions about AOL's instant-messaging service. WorldCom Inc., the dominant carrier of Internet traffic, has seen its stock hammered since a proposed merger with Sprint Corp. was derailed by antitrust concerns.

Moreover, monopolies may erode as the marketplace evolves. Beyond the government antitrust suit, Microsoft faces the far more daunting danger that its customers will reject the desktop computer as online and wireless technologies open the way for new handheld devices and inexpensive "dumb" terminals that can connect to the Internet.

Mr. Mauboussin notes that he always acknowledged that some network effects are stronger than others and that in technology, the effects tend to have a shorter life span than elsewhere.

Myth No. 4:

Exponential Internet growth has just begun and, if anything, will accelerate.

J. Thomas Madden, chief investment officer at the Federated Investors Inc. mutual-fund group in Pittsburgh, a one-time skeptic of tech stocks, gradually found himself embracing the idea that the Internet would strongly influence the future of the stock market. He recalls being told by a scientist at Carnegie Mellon University that if you plotted on a chart the number of Internet users or of network parts needed, it would rise geometrically.

When an investor "begins to believe that such growth may continue for years to come, it is easier to withstand very lofty valuations," Mr. Madden has explained.

But demand for Internet products and services, though strong, hasn't proven infinite. Once most companies set up a Web strategy and a home page, growth in their Internet spending tends to slow. As the overall economy has downshifted a bit, Internet-advertising dollars have flowed less readily. Last week, the stocks of Yahoo! Inc. and DoubleClick Inc. were clobbered on signs of flagging growth in Web advertising, finishing the week down 76% and 91% from their highs, respectively.

What's more, Internet companies had assumed shareholders would wait patiently for years before demanding that they show significant profits. Instead, investors are bailing out of companies that spent aggressively on attracting customers: Amazon.com Inc. is down 75% from its all-time high, E*Trade Group Inc. 81%, and iVillage Inc. 98%.

The myth was "that there was no price that was too high for a good tech company," says Ed Keon, director of quantitative research at Prudential Securities, himself a reformed advocate of high-priced technology stocks. But "eventually, there is a price that is too much to pay even for a fabulous stock such as Cisco Systems or JDS Uniphase," makers of communications equipment used in building the Internet. "At some point," Mr. Keon says, "you had to ask yourself, wait a minute, is there anybody left that doesn't have a Web site now?"

Myth No. 5:

Prospects are more important than immediate earnings.

Henry Blodget of Merrill Lynch expressed the core of this myth in December, when he wrote of Internet leaders like Yahoo! Inc., "It is a mistake to be too conservative in projecting future performance." Yahoo at that time was trading at 500 times projected profits for 2000. "The real 'risk,' " Mr. Blodget asserted, "is not losing money -- it is missing major upside."

Today, investors are nervous about Yahoo's slowing revenue growth, and the company's stock is down 68% since December. In retrospect, Mr. Blodget concedes that while advising investors not to be too conservative "was the right prescription for 1995 to 1998, as soon as we got into 1999, it was a mistake. Expectations got ahead of reality." Valuing these stocks on prospects and potential size of market sometimes made analysts forget what could change -- such as competition. FreeMarkets Inc., which operates online auctions for industrial companies' purchasing needs, went public at $48 last December. By February, when co-lead underwriter Goldman Sachs & Co. initiated coverage, it was trading at $217. Goldman analyst Jamie Friedman said that in six to 12 months, the stock would be worth between $300 and $400. That was based, among other things, on the expectation that FreeMarkets would eventually handle 5% of an estimated $5 trillion in global procurement. But FreeMarkets' potential customers saw similar opportunities and began forming their own online procurement consortia. Since February, FreeMarkets has lost 81% of its value. Mr. Friedman says he didn't foresee the creation of competing consortia.

Myth No. 6:

This time, things are different.

More than any other misconception, this was the most fundamental of the myths to which people succumbed. And like many of the others, what made it so seductive was that it had so many elements of truth to it.

Rarely had a series of phenomena -- the Internet, wireless communications and computer networking -- so quickly become such a big part of so many people's lives. Analysts compared the situation to revolutionary developments of the past -- the popularization of the telephone, radio, television and car -- all of which took far longer to grab the national consciousness.

But tech fans ignored the fact that even companies involved in a revolution eventually face market forces. Most early auto makers failed to survive. Radio Corp. of America and General Motors Co. were two of the hottest stocks of the 1920s, but that didn't prevent both from crashing along with the rest of the market in 1929. RCA eventually lost 98% of its value.

Some analysts remain unrepentant defenders of their views on tech stocks. Mr. Steinberg of Merrill Lynch says he never tried to justify the highest of the tech valuations. As for the rest of the sector, he adds, it will recover. "I think the new economy is alive and well," he says, "and I don't think this is the end of the story right now."

But some money managers warn that certain tech stocks, notably in the networking and optical-fiber area, still haven't fallen enough to reflect the real world. Says Michael Weiner of Banc One Corp.'s money-management unit in Columbus, Ohio: "It doesn't look to me like we have entirely learned our lesson."

Write to E.S. Browning at jim.browning@wsj.com and Greg Ip at gregory.ip@wsj.com

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