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Adam Hamilton

Adam Hamilton

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing…

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Computers and Tech Stocks

If one had to choose the single innovation most responsible for the birth of the Information Age, the personal computer would certainly be one of the top finalist contenders. Personal computers have changed all our lives in ways we couldn't even dream of 20 years ago.

While two decades seems like a relatively long time in terms of a single human lifespan, it is a trivial drop in the bucket when compared to six thousand years of relentless technological progress. Other crucial innovations, such as the use of irrigation and the printing press, took centuries or more to totally alter the face of human civilization. In reminiscing back on the entire Personal Computer Age of the last two decades, it is wondrous to behold just how widespread and pervasive the computer's impact has truly been in such a small sliver of time.

All this and the PC is still in its infancy in technology terms! I strongly believe that it is a near 100% certainty that the computer's impact during the next two decades will vastly exceed anything we saw in the past two decades or can even imagine today. I can't wait to see what dazzling innovations evolve in all areas of life and commerce thanks to the wonders of personal computing.

I remember the day in 1983 when I got my first computer like it was yesterday. The machine was an Apple IIe, a simply amazing piece of technology. It came with 64k of RAM and was expandable to a whopping 128k. The box had no hard drive but the computer came with a separate floppy drive that used 5.25" floppy disks. Its central processing unit ran at a blistering 1Mhz. Apple produced the IIe for over a decade and it was one of the most successful Apple computers in history.

It was such an amazing feeling to have a personal computer! Before the early 1980s, only government agencies, huge corporations, and technically-adept hobbyists had access to anything even resembling a computer. That fateful day in 1983 changed my life forever.

The Apple IIe did a lot of the same things computers do today. There was a word processor, called AppleWriter, where you could create documents. It was such a fantastic innovation because, if a mistake was made, it was a piece of cake to backspace, fix the error, and move on. If you are old enough to remember the days of typewriters when a single mistake could ruin an entire page or at least necessitate sloppy mechanical corrections, you can truly appreciate the glorious dawn of AppleWriter.

I also fondly remember a fantastic spreadsheet program called VisiCalc. VisiCalc was a lot like Excel today, with rows and columns in which you could place numbers for calculation. For a numbers guy like me, it was like heaven on earth! Rather than doing any calculations by longhand or with the infernal 10-key calculators, using VisiCalc allowed vast amounts of data to be processed very rapidly. Even better, if one cell changed the rest of the spreadsheet automatically changed with it. No more manual recalculations!

VisiCalc vastly expanded the ease of analysis, financial modeling, and data graphing. Some market historians even believe it had a major role in feeding the US stock market frenzy that led to the crash in 1987! VisiCalc truly was the original "killer app" that drove enormous Apple IIe sales and created a near insatiable demand for the wondrous machines.

Today I am writing this essay on a small Dell laptop I bought 16 months ago. It has 512,000k of RAM, as much as 8000 Apple IIes! Its Intel Pentium III heart runs at 850Mhz, over 850x faster than my beloved Apple IIe did. The laptop's hard drive can store 62,500x as much data as the floppy drive on the Apple IIe. My current desktop PC, a fire-breathing Pentium 4 2.2Ghz box I bought this January, can burn through code at least 2200x faster than the Apple IIe. The advancements in personal computing in two short decades have been truly astounding!

In light of the immense impact personal computing has already made on our lives and the perpetually accelerating computer advancements that will lead to innovations we can't even dream of, it is no surprise that today's elite companies in the personal computer arena are stock market leaders.

No one can dispute that today's computer market is utterly dominated by three fantastic and monolithic US corporations, Microsoft, Intel, and Dell. Microsoft programs the software that allows us humans, the wet-ware, to interact with the hardware and do useful tasks with our computers. Intel creates the brains of the machines, the central processing units and the core chipset. Dell is the leading box maker that puts the parts together and ships them out around the world.

There are also other companies very important to the current computer market. Apple still makes awesome and elegant machines and has the best operating systems in the world. NVidia has become the Intel of the computer graphics world, dominating PC graphics processing chips with its vastly superior technology. AMD continues its aggressive assault on the Intel juggernaut and is zealously trying to stake a claim in the lucrative CPU marketplace. The list of other players goes on, but MSFT, INTC, and DELL truly dominate the playing fields in their respective core competencies and define the computer market for all the other players.

I am personally so hopelessly addicted to fast computing that I buy one new box every year for my own use, alternating between a new laptop in odd years and a new desktop in even years. Once one of my own computers reaches the ripe old age of two, as far as I am concerned it has served me well and it is put out to pasture for a nice retirement. At this point in my life, I will not even consider using a non-Microsoft operating system or productivity software, a non-Intel processor, or buying from someone other than Dell. These three companies have served me incredibly well through many generations of their fine wares and I have never been disappointed with their world-class products.

Both as a computer zealot and private investor, I truly tremendously admire MSFT, INTC, DELL, and the brilliant men and women behind them. I think they are among the greatest companies on earth and they are all glorious testaments to the inspiring spirit of entrepreneurial capitalism that has always defined America.

For investors, however, there are very important things to consider other than the pedigree of a company and the dominance of its technology when making investment decisions. Investors deploy their scarce surplus capital into equities in the hopes of earning a fair and reasonable return. Even if the Big Three continue to dominate the PC market well into the future, that fact does not necessarily mean that they are a good investment at a given moment in time.

Obviously I am not the only one who holds these three American success stories in such stellar esteem, as the following graph indicates. It shows the market capitalization of the NASDAQ 100, the 100 biggest and best companies on the NASDAQ. The market-caps of NASDAQ 100 components Microsoft, Intel, and Dell are shown as separate colors against the overall NASDAQ 100 market capitalization. The data in this essay is monthly data for the two years ended in May 2002. As of the Friday afternoon this essay was published, we did not yet have the new June 2002 month-end data collected and collated to continue the series.

Even marching through the very midst of the valley of the shadow of death in the horrible bear market in the NASDAQ since March 2000, the three dominant PC companies have held their ground remarkably well.

Computer Dominance of the NASDAQ 100For those of you keeping score, you will certainly recall that one of the key Wall Street rallying cries for the first 18 months after the NASDAQ crash was to "buy, buy, buy the NASDAQ mega-caps." The theory stated that the elite market-darling NASDAQ stocks would hold up well through the turbulent times because their underlying businesses were so sound. While this idea didn't help all tech investors such as shareholders in Cisco, Oracle, and Sun, our Big Three PC companies did hold up relatively well in the midst of the carnage of the bust.

From the NASDAQ bubble top of March 10, 2000 to May 31, 2002, the elite NASDAQ 100 lost 73.7% and the NASDAQ composite hemorrhaged 68.0%, seemingly refuting Wall Street's solemn promises of the summer of 2000 that the tech big caps would fare the best. During this same time frame, however, Microsoft "only" fell by 49.6%, Intel by 53.8%, and Dell by 47.6%. In the case of the Big Three PC stocks, they have weathered the storm of the bursting tech bubble fairly well compared to thousands of other NASDAQ stocks that have seen their share prices practically obliterated.

Fellow NASDAQ mega-caps Cisco, Oracle, and Sun lost a nauseating 76.9%, 80.6%, and 85.4% of their values, respectively, over the same time frame! While the NASDAQ mega-caps as a safe-haven theory proved to be yet another dismal Wall Street failure, of all the mega-cap NASDAQ darlings dominating the NASDAQ and NASDAQ 100, the elite PC companies have held up the best by far. There is a vast, vast difference in severity between losing 50% and losing 80%! A 50% drop in price requires a 100% gain to get even, difficult to achieve. Yet, an 80% price plunge requires an all-but-impossible 400% gain to break even. An entirely different ballgame.

While the PC giants, relative to other fallen NASDAQ market-darlings, have been pillars of strength in a vicious post-bubble bear market, their dominance has led to a provocative development. The next graph shows the percentage of the total market capitalization of the NASDAQ 100 that Microsoft, Intel, and Dell consume. P/E ratios for each company and the NASDAQ 100 from two years ago, one year ago, and the end of May are also shown below.

Rising Expectations

Amazingly, at the end of May 2002, the Big Three PC companies together accounted for 38.5% of the total value of the NASDAQ 100! As the NASDAQ 100 stocks generally approach 2/3 of the total market capitalization of all 3700+ stocks listed on the NASDAQ, the proportion of the whole index that merely three computer companies comprise is simply staggering.

This observation leads to an absolutely crucial question for tech investors. Can this PC stock utter dominance of the NASDAQ continue into the future? Is it possible for 3 companies to be worth more than the 97 other NASDAQ 100 companies combined if this trend continues to 50%? If the answer is no, then hundreds of billions of dollars of investors' scarce capital is at risk as MSFT, INTC, and DELL lose their elite pillar-of-strength status in the coming year.

Unfortunately for tech investors, I believe the odds are that the Big Three dominance effect is indeed unsustainable into the future for fundamental, consumer, and technological innovation reasons.

Fundamentally, even though it is undisputable that the Big Three are world-class corporate powerhouses, they remain vastly overvalued. Throughout the history of US stock markets, corporations have generally had an average P/E ratio of 13.5x earnings. So-called "growth" companies, those that were growing profits much faster than their peers, often gained a reasonable premium for their earnings growth. While we unfortunately don't have the historical data to verify this, I suspect that a reasonable long-term average mature growth stock P/E in the last century didn't exceed 20x earnings or so.

By that estimate, at the end of May MSFT was trading at least twice as high as it should, DELL almost three times too high, and INTC a whopping five times too high. Investors buying growth stocks demand exceptional earnings growth for the premium they pay, but as the PC market matures it is becoming more and more difficult for the Big Three to grow at all, let alone fast enough to command a growth premium. Tech investors face some very tough sailing ahead as the markets begin to question stellar growth premiums in valuation on companies that can no longer manage to attain rapid growth.

Another fundamental factor boding ill for the Big Three's valuations and share prices is the relative overvaluation of the PC sector compared to other market sectors. Today's investors have a whole world of investment options available to them and they can move vast amounts of capital at the speed of light with a click of the mouse. If the high-profile PC industry is not providing the earnings, what will keep investors from selling PC stocks and moving their capital elsewhere to take advantage of far more reasonable valuations, lower risk, and superior returns?

Investors have been burned severely in the past two years by buying overvalued stocks, and odds are they will sooner or later grow nervous with the extreme PC valuations and capital will start fleeing to other sectors with lower valuations and better prospects for choppy markets.

The largest markets for the Big Three are American consumers and corporations. These massive markets for PCs are sagging, and for good reason.

First, the very difficult economy aside, for the vast majority of computer users an older slower machine works perfectly well for today's popular applications. While there are lots of power-users like me willing to spend whatever it takes to run the fastest machines, we are definitely a tiny minority. An old 500Mhz PC is only slightly slower than a brand new P4 powerhouse for the usual-suspect applications like e-mail, web surfing, and running office productivity software. Today's major applications, unlikely to evolve dramatically in the next 12 months, simply don't need all the computing power available.

Windows XP is certainly pretty and a great OS, but its NT core is not a big improvement over its ancestor Windows 2000 which most US corporations use. I live and die by Microsoft Office and use both the 2000 and XP versions religiously today, but I don't believe there have been any major new features since Office 97, two generations ago. As most computers built in the last three years run the typical popular software perfectly, there is little software incentive in the current market for corporations and consumers to upgrade to faster machines and newer versions of software. Killer apps have gone MIA!

In the consumer sector, the only folks who really need bleeding-edge machines are the hardcore gamers, also a small minority of total computer users. Video games are a massive industry that dwarfs Hollywood movies. The average PC gamer, amazingly enough, is 31 years old. These gamers lust after high-end rigs running $2500 and higher, but many are in the stage of their lives with young families to support where they can't afford to spend thousands of dollars on a what is ultimately a glorified Nintendo. Gaming PC demand is also in trouble because most gaming enthusiasts work for tech companies that have been laying off people in droves. With so much job security uncertainty abounding, expensive cutting-edge gaming rigs are not going to sell as well.

Second, most corporations and consumers are up to their eyeballs in debt and just trying to ride out and survive the brutal post-bubble economic and market environment. Even cheap $700 computers are a big purchase for most Americans who live paycheck-to-paycheck, and during tough times a blisteringly fast computer is a luxury. Until the stock markets and US economy really start improving, it is hard to imagine a big surge in PC-related demand from either corporate or consumer buyers.

In my opinion a PC is a necessity in the Information Age, but any configurations over the inexpensive bare-bones boxes are luxuries. The most important thing for consumers is to have access to the endless resources of the Internet, and web browsing works perfectly on a low-end machine.

Finally, relentless innovation is leading to new disruptive technologies that are replacing the mighty PC for certain specialized applications. One particular shining example that has captured my attention recently is the network MP3 player.

Music is wonderful, but CDs are a pain. They are fragile, bulky, and easily scratched. Many computer users have copied the CDs they purchased onto their computer hard drives. That way, whenever they are at their computer, they can listen to the music off their purchased CDs without dragging out, juggling, and risking their valuable CDs themselves. The CD audio is often encoded in a compressed music format called MP3. The primary problem is these MP3 libraries can only be savored in one's computer room or via a portable Walkman-type device, not in a TV room, bedroom, or out on the deck with barbecue dinner guests.

I just bought a wonderful gizmo from a young Silicon-Valley startup company named Slim Devices. It is a small, elegant MP3 player that plugs into your home network and can then play any MP3 music files you have stored on your computer through your home stereo. The device, the SliMP3, is amazingly well-designed and a perfect solution for computer music lovers who don't want to clutter their living room with an old computer next to their stereo. I can't recommend this awesome device highly enough and I am going to buy a few more for other rooms!

While network MP3 players remain trivial relative to total PC demand, they are a great example of a disruptive technology that cannibalizes existing PC demand. The old solution to this dilemma two years ago was to buy a separate PC for whatever room of your house you wanted to play your digitized music in. Now, thanks to bold entrepreneurs like the founders of Slim Devices, music lovers can buy several SliMP3s for less than the price of a single cheap new computer. The net result? Lower PC demand!

Over time I suspect that more and more disruptive new technological innovations will be unleashed that obsolete computers for certain peripheral applications. This ongoing process will continue to gradually eat into overall PC demand at the margin across multiple fronts.

When the current stellar valuations of computer stocks are combined with slowing consumer and corporate PC demand due to the poor economy, the lack of innovation in software, and the rapid innovation in computer substitutes for certain specialized applications, the Big Three dominance of the NASDAQ looks like an investment accident waiting to happen.

While I absolutely love the products of Microsoft, Intel, and Dell and I will continue to eagerly patronize these fine corporations both individually and through my company in the future, as an investor I don't believe the PC environment for the coming year will justify their overvalued status. If the NASDAQ keeps falling, as I suspect it will, there is no reason to believe that the elite Big Three PC companies will continue to weather the storm. It is hard to imagine them rising to 50%+ of the total value of the NASDAQ 100, for instance, given the lackluster PC environment!

Tech investors ought to carefully examine the PC companies and divorce their zealous love of technology with their need as investors to prudently buy low and sell high. Yes, the PC will be around for decades and continue to grow better, but history clearly teaches that overvalued stock markets and individual stocks are not sustainable.

So far during the brutal NASDAQ bust the PC companies have been solid pillars of relative strength, but odds are they will not weather the next NASDAQ downleg so admirably.

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