Four years and four months ago, on March 10, 2000, the Nasdaq Composite Index, representing the cream of U.S. technology and innovation, closed the trading day at an all-time high of 5,048.62.
This past Friday … even after the most massive government effort to pump up the economy in recent history … and even after nearly 20 months of intensive Wall Street cheerleading … the index closed at 1,883.15.
If you invested $10,000 in a portfolio representing the average Nasdaq stocks at their peak, you’d have only $3,730 left today.
Despite all the double- and triple-digit gains many tech stocks have enjoyed since late 2002, you’d still be looking at a loss of 62.7%.
This is the harsh reality of tech-stock investing in the twenty-first century. And if this month is any indication, the tech stock woes are far from over:
- Since the end of the second quarter, the Nasdaq Composite has fallen 164 points or 8%.
- It’s been down for three consecutive weeks and for the last five days in a row.
- Right now, it’s trading at the same level as it was in both August and November of 2001, one month before – and two months after – the 9/11 attacks.
- If it falls just another seven points, it will be at the lowest level of 2004.
- Rallies are always possible. But if it loses another 10% or so, it will be down to the same level as September 10, 2001, the day before the terror attacks.
The Nasdaq is also infecting the S&P 500 Index, which has just posted its fifth straight weekly decline, its longest losing streak since October 2002. It’s dragging down blue chips, mutual funds, and the general mood of Wall Street.
WHY?
For an answer, I called my good friend Tony Sagami, who often sees the world from a different place than I do, especially when it comes to technology and tech stocks.
Remember the little kid in your middle school math class who sat at the front of the row and was always the first to pop up his hand with the right answers? That could easily have been Tony Sagami.
Today, he’s still a numbers cruncher and math whiz. Plus, since the 1990s, he’s been the owner of a small software company and part owner of a not-so-small, Internet-based ASP (application service provider).
Yesterday afternoon, I reached him in Western Montana, where he’s recently moved from Austin, Texas. I asked him what he’s doing there.
“I’m a family man,” he answered proudly. “I’ve got four great kids. I’ve only been married once. And I’m 100% positive I’ll stay that way till the day I die.”
“But why did you move to Montana?” I queried.
“So my kids could live close to their grandparents. So they could learn good values and work ethics, the kind you can only learn from living in a rural, farming environment like this one. My father was a farmer. And his formula for success was pretty simple: Wake up before the roosters and keep working until it’s time for the 10:00 p.m. news.”
He paused for a moment while he sought the connection to what’s happening in the stock market. Then he continued. “But that’s a far cry from the values and work ethic in most of corporate America today, especially the high-tech companies. They spend too much darn money.”
“What about your two tech companies?”
“They’re the exception that proves the rule. We run them with frugality and hard work, and they’ve been profitable throughout the whole debacle.”
“And your own tech stock investments?”
“Since I’m in the industry myself, I can see each and every business day all the garbage that’s going on. So I avoided investing in the hot-shot stocks that crashed and burned. But I’m not telling you this to brag. I’m telling you so you’ll understand why I think the numbskulls on Wall Street are so darn wrong about the future of the Nasdaq and tech stocks.”
THE SQUEEZE
I asked Tony to give me some more details, and a short while later he sent me a Word file with some of his thoughts. Then we talked again to follow up.
“The dynamics of my own high-tech businesses are changing in two key ways,” he explained. “My expenses are exploding. And my average sales ticket is shrinking.”
“Which expenses?”
“Start with health insurance. My health premiums are going berserk. I must have gotten hit with at least a 20% increase every year for the last four or five years. Just for my wife, my children, and myself, the premium is now almost $1,000 a month – not to mention the 75 other people we employ. But health insurance is nothing compared to wages.”
“Aren’t wages a big cost for any business?” I asked.
“Sure. But they’re especially big for tech companies like ours. We don’t spend hundreds of millions on airplanes or state-of-the-art manufacturing plants. We don’t build off-shore oil rigs or skyscraper hotels.”
“What DO you need?”
“The only things we need are office space, a bunch of desks, lots of cheap PCs, and an army of nerds. Instead of capital equipment, what we buy most of the time is millions of dollars worth of intellectual capital, which is why the biggest expense is wages.”
“So …”
“So in my business, rising wages are just as onerous as rising oil for the airline industry. And you can bet your bottom dollar that higher wages are affecting darn near everybody in this industry.”
I was a bit perplexed. In the Sunday New York Times yesterday, the lead article was all about falling wages … or wages that failed to keep up with the pace of consumer price inflation. I asked Tony to explain the discrepancy.
“That’s mostly services and low tech. Right now, high tech is getting socked with rising wages, which is one of the reasons profits are so disappointing.”
LOST PRICING POWER
We talked about the string of profit warnings from tech companies that have come out in recent weeks. Then Tony brought me back to his own experience.
“The other thing that’s squeezing our profits,” he remarked, “is the prices we can charge. In my companies, we’re having a real tough time charging what we used to. Prices of most things are going up all around us. But in the technology world, falling product prices seem to be the norm.”
“Why’s that?”
“Typically, as a technology matures, the price falls. That’s true whether you’re talking about a Texas Instruments calculator, a Dell computer, a cellular phone call, or a Sun Microsystems server. Prices drop.”
“Is that always true?”
“Almost always. So usually, the only way to restore pricing power is to come out with new, killer applications and technologies that you can charge more for. That’s how the industry maintained its pricing power in the past.”
“What about now?”
“Now, I don’t see hardly any new killer apps. It’s just not happening in most tech sectors. Typically, the only new products I see are enhancements and embellishments of stuff that has already been out there for at least a few years.”
CUT-THROAT COMPETITION
I felt this was critical. So I pressed Tony for more details. “Specifically, how bad is your loss of pricing power?”
“Right now, in my business, we’re getting about 30% less for our services than we were two or three years ago. That’s not good.”
“Do you know what’s driving prices down?”
“Do I know? Are you kidding? I’m battling them almost every day.”
“Them?”
“Two of our competitors. They’re so damn desperate for business they’re slashing prices to the bone. I think both of them could go out of business in the not-so-distant future. With the kind of prices they’re charging, I know they can’t be making a profit. But in the meantime, they’re hurting everyone in our business by pushing prices down.”
As Tony talked, I recalled the days when Pan Am and Braniff Airlines were going through bankruptcy. Just to bring in some desperately needed cash flow, they slashed their prices below cost, nearly dragging healthier airlines down with them.
“Thank goodness we’re still profitable,” Tony said, breaking into my thoughts.
“How do you do that?”
“Three things: First, sweat and hard work. Second, no debt. We avoid debt like fanatics. Third, we’re penny pinchers. Instead of spending big on equipment outlays, we buy a lot of stuff in bankruptcy auctions.”
“Give me an example.”
“For example, every company like ours needs a back-up power source in the event of a prolonged power outage. A commercial-sized UPS – uninterrupted power source – can cost more than $100,000. But we bought a barely used one for only $5,000. We just went to an auction of a failed dot-com.”
“Five cents on the dollar, eh?”
“Yup. And by the way, that’s also an example of hard work and sweat. The darn thing weighed 2,000 pounds and was a nightmare to move.”
SLOW SALES GROWTH
I asked Tony where he sees things going from here – not just for his companies but in the software and high-tech industry as a whole.
“No matter how much we watch our pennies, we’ll never succeed unless we’re delivering solid sales growth. Cutting costs is important. But it’s not nearly as important as growing the top line. That’s a lesson many big-name technology companies don’t seem to have learned yet.”
“What about IBM?”
“In 2003, IBM pulled in about $89 billion worth of revenues. That sounds like a ton of business, right? But it’s not much when you realize that IBM pulled in nearly $88 billion of sales in 1999.”
“So?”
“So you know how much their top-line sales growth was for the past five years? Less than one percent! That’s an average of under two-tenths of a percent per year. Pathetic, right?”
Tony paused for a moment to check some other numbers. Then he went on to explain that IBM isn’t the only tech company with a weak sales growth rate.
“Here,” he said with emphasis. “Consider these figures:
“Sun Microsystems – 3.2% …
“Intel – 2.8% …
“Mic …
“These numbers are what again?” I asked, interrupting for clarification.
“TOTAL sales growth over the past FIVE years. May I continue? Here goes …
“Micron Technology – 0.5% …
“Oracle – 2.8% …
“Qualcomm – 3.5% …
“Applied Materials – 2.1%. Plus, don’t forget the techs with negative sales growth in the past five years …
“Lucent, down 22.4% …
“Gateway, down 14.6% …”
FREE PASS?
Some people on Wall Street still seem to believe that the technology business deserves a free pass on basic economics simply because they produce hot, exciting products.
Tony’s main point was that tech companies are no different from any other company. They have revenues. They have expenses. If they lose control over either one, you get lower profits – or losses.
“Forget all the mumbo-jumbo,” he concluded. “Just look at tech companies as a business person would – not as an investor or as an analyst. You’ll see an industry that’s STILL priced ridiculously high, despite the two-thirds wipe-out from the peak to today.”
Wall Street analysts haven’t quite figured this out yet. When they do, watch out. Tech stocks could plunge a lot further.
Good luck and God bless!
Martin
Martin D. Weiss, Ph.D.
Editor, Safe Money Report
Chairman, Weiss Ratings, Inc.
