SPECIAL EDITION: Where's the Beef?
By James J Puplava CFP and Eric King, October 20, 2003
Fundamental Review by Jim Puplava
On Wall Street they are getting ready to pop the champagne bottles again as the Dow heads towards 10,000 and the NASDAQ is approaching 2,000. For Wall Street and investors it has been a pretty good year. The S&P 500 is up 18% and the NASDAQ has gained over 43%. We haven't seen these kind of numbers since 1999. The consensus is that this year will end up being a blowout year for stocks and next year could be equally as rewarding. Behind the rise in stocks is a belief that the long-awaited recovery has finally arrived. Economic growth has been strong, earnings have improved, and as a consequence, stock prices are on the mend. Talk everywhere is that the fundamentals are improving, business conditions are getting stronger, and the American consumer continues to borrow and spend money. More importantly in Wall Street's opinion is that Fed policy remains favorable and should remain so until the economy is on firm ground. The advice to investors is to be long stocks.
Like the last bull market, the same sectors are leading the market. Technology stocks, Internet companies, or anything remotely connected to technology has been on a tear lately. Consider the fact that Amazon.com is up 213% this year. The company has yet to earn a profit and remains one of the most expensively priced stocks in the retail sector. Its market cap is 12 times greater than its competitors Barnes & Noble and Borders. It also remains twice as expensive as other retailers such as Costco, May Company, Federated, and Sears.
The mania in technology has carried through all sectors of the technology arena. Like the technology mania in 1997-1999, investors are once again bidding up the shares of companies that are losing money, barely making a profit, or more recently just turned a profit. The zealous appetite to own technology shares is evident everywhere you look within the technology sector. Like 1999 investors are bidding up shares while company insiders cash in, dumping their holdings at a record pace. The degree of insider selling over the last four months is unlike anything we have ever seen before.
So, who's buying and why?
If insiders are selling, who is buying? The answer to that question is easy, everyone from institutional investors to the general public. Institutional investors are more fully invested than at any time in the past three years. The public is coming back into the market with margin debt now at its highest level in a year. Day trading is also making a comeback.
The two main reasons driving this market is the much touted second-half recovery. The economy is expected to boom along with it corporate profits. The company's expected to be in the forefront of this recovery are technology and energy stocks. Energy companies from ExxonMobil to natural gas producers like Apache are reporting stellar profits. Energy has accounted for a good bulk of the profits this year within the S&P 500. Yet the stocks have virtually gone nowhere by comparison. The money is going mainly into technology. This is reflected in the fact that the bulk of this year's gains has occurred in technology; a fact that is reflected by the gulf between the NASDAQ and the S&P 500. However, that isn't where the money is going. The bulk of this year's gains have occurred in the technology sector. The NASDAQ is up over 43%; while specific tech sectors such as the SOX (The Philadelphia Semiconductor Index) is up 62% this year. The Internet sector is up even more. Amazon.com is up 212%, Drugstore.com is up 221%, Homestore is up 295%, and Priceline.com is up 205%. Today's manic rise in technology is almost reminiscent of the technology mania of 1999.
Are today’s prices justified?
Have industry conditions improved enough to justify today's valuations? Is this the start of another technology boom that will parallel the 1990s? Technology strategist Fred Hickey doesn't think so. In Fred's latest newsletter Fred points out a very important lesson that plagues this industry which is "obsolescence." The dirty little secret in tech investing is that virtually no one can buy great growth stocks and just put them away in a drawer. It is a game of Greater Fools." The dustbins of technology are filled with bankrupt, obsolete, merged, or fallen former stars. Does anyone remember Atari, Commodore International, Amdahl, Digital Equipment or Data General?
I decided to look at the tech industry, narrowing my search to the SOX with a closer look at one Internet flyer in particular Amazon.com. What I wanted to know was whether the fundamentals of the tech industry are improving or is this just a temporary boost driven by cost cutting? Specifically, what I wanted to examine is what has happened to this industry over the last five years. I have chosen the five largest cap stocks within the SOX for my examination. I wanted to know if conditions have improved. Have sales and margins gotten better and more importantly, what has happened to return on equity, the most important yardstick of management's performance? This is what I found. The data I examined where taken from Bloomberg spreadsheets. They include the most recent five years of financial reports. I have not included this year's gains which are up for some companies over last year. The reader will find the earnings reports for this year in a separate table at the end of this report.
Table 1: PROFIT MARGINS (as Percentage)
Operating Margins (OM) & Net Profit Margins (NPM) 1997 - Present
|- 3.27||2.69||3.51||- 13.18||- 9.31|
|Texas Instruments||4.78||17.98||19.70||- 7.10||3.44|
|4.83||14.87||25.75||- 2.45||- 4.10|
Profit Margins Show Higher Accruals
The first table reflects profit margins for the large cap SOX companies. They peaked for all five companies in 2000. The year 2000 was also a year when accounting accruals grew faster than earnings and cash flow. The subsequent years were filled with write-downs and write-offs. When net income is growing faster than cash from operations, the difference between the two amounts is caused by accruals. This is the component part of the business that isn't backed by cash. Rather, it is based on accounting rules and managerial estimates. Whenever the accrual side of the accounting ledger is growing faster than the cash side of the business, it means that accruals are getting larger and larger. It should make the investor suspicious about the company's accounting decisions. Companies with a pattern of rising accruals over cash are more likely to suffer large write-offs in the future when it turns out that the company's prior accounting was too aggressive.
After examining the margin side of the business, I then looked at turnover ratios to see how well these firms were utilizing assets to generate sales. Inventory turnover, inventory days, and the net fixed asset turnover were looked at. As I suspected, the same trend in asset utilization could also be viewed. The trend in poorer utilization of assets was following the trend in profit margins. Time did not permit covering all turnover ratios such as net working capital turnover. Although not shown, the same deteriorating trend was visible.
Table 2: OPERATING EFFICIENCY RATIOS
Inventory Turnover (IT), Inventory Turnover Days (ITD) & Net Fixed Asset Turnover (NFAT) 1997 - Present
Net Profitability Declining
The final table shows the decline in net profitability as shown in the return on assets and the return on shareholder equity. These two measures are the most important in relation to looking at a company's long-term growth prospects. That is because what we want to know is what are the firms capability of sustaining its internal growth without having to overpay for it through acquisitions. The sustainable growth rate is reflected in what a company can earn on the equity and how those profits can be redeployed. The formula for sustainable growth is shown below.
Sustainable Growth rate = Return on Equity X (1-Dividend payout)
Given the firms current level of profitability, the sustainable growth rate is the rate is the maximum rate at which a firm can grow without additional external financing. Investors should be leery of analyst's forecasts of sales growth that exceeds a company's sustainable growth rate. That is why ROE (Return On Equity) is so important. It shows internally what management is capable of earnings on sales and what is left in the business to drive future profits. Profitability has dropped substantially over the last three years both on assets deployed and the net equity of the firm.
Table 3: PROFITABILITY (as Percentage)
Return on Assets (ROA) & Return on Equity (ROE) 1997 - Present
|Motorola||- 3.4||2.6||3.2||- 10.4||- 7.7|
|- 7.6||5.8||7.1||- 24.4||- 20.0|
|Texas Instruments||3.7||10.8||18.5||- 1.2||2.3|
|6.6||17.8||27.6||- 1.6||- 3.0|
Analysts today use measures such as the Dupont method to decompose ROE to get a better understanding of what drives returns. The basic ROE calculation is as follows:
|ROE = Net profit margin (x) Asset turnover (x) Total Leverage|
|Net Income||(x)||Sales||(x)||Average Total Assets|
|Sales||Average Total Assets||Average Common Equity|
Although today the Dupont is popular for looking at a company's profitability, I prefer to use the Advanced Dupont method which isolates operating performance much more cleanly. This method isolates the effects of operating decisions from financial decisions to give the investor a clearer understanding of what is going on the operating side of the business. The formula is as follows:
ROE = RNOA + Leverage (x) Spread
Under this method of analysis, a firm's return on operating assets the main business of the firm can be isolated from its net financial obligations from debt and preferred stock. Furthermore, an investor can look at what the company's net borrowing costs (NBC) are to see if the company is earning enough from operations to meet its debt obligations. The extent to which ROE exceeds RNOA (Return On Operating Assets) depends on the Spread between RNOA and NBC (Net Borrowing Costs), and the amount of leverage the firm uses. The advantages of this approach to decomposing firm's ROE (Return on Equity) is that net operating margins of running the business isn't polluted by interest expense or preferred dividends as in the basic Dupont Model. In addition, the impact of operating liabilities is very different between the two models.
Investors Are Overpaying
As Table 4 indicates, operating returns on assets have dropped dramatically over the last few years. In the case of Motorola and Texas Instruments operating returns as reflected in RNOA aren't even covering the net borrowing costs of the firm. Furthermore, as shown in Table 5, investors are overpaying for these company's as shown in the P/E multiples, PEG and price to sales ratios illustrated in the table.
Table 4: RETURN ON OPERATING ASSETS (RNOA) (as Percentage)
1999 - 2003
|Motorola||5.2||6.3||- 13.3||- 10.4||- 9.5|
|Texas Instruments||15.8||25.3||- 1.3||- 2.3||- 1.4|
Table 5: RETURN ON EQUITY (ROE) COMPARISON (as percentage)
Sustainable Growth ROE = (1-Dividend Payout) 1998 & 2003
|Motorola||- 3.4||2.6||3.2||- 10.4||- 7.7|
|Texas Instruments||3.7||10.8||18.5||- 1.2||2.3|
|P/E = Price/Earnings Ratio, PEG = Price Earnings/Growth Ratio, P/S = Price/Sales Ratio|
The next table shows year-over-year earnings comparisons, which have improved somewhat over last year but not by much. Certainly not as much as the pro forma numbers so widely used in press releases and quoted on cable TV. If we extrapolate this year's best quarterly earnings forward, Applied Materials is selling at 108 times earnings, Intel is selling at 31 times earnings, 50 times earnings for Linear Technology, 55 times earnings for Motorola, and 71 times earnings for Texas Instruments.
Table 6: YEAR-OVER-YEAR EARNINGS COMPARISON
by quarters 2002 & 2003
|Applied Mat.||Intel||Linnear||Motorola||Texas Inst.|
High Profitability Doesn't Last
What is evident from examination of the SOX Index is that the technology industry is a cyclical industry just like the auto industry and any other industrial industry dependent on the economy's health. What is also transparent is that the technology industry is a maturing industry subject to obsolescence, competition, and lower returns just like all other industries. Highly profitable industries tend to revert to the mean over time due to competition. The reason that high ROE industries see their returns lower over time is competition becomes an equalizer. If a firm enjoys a high return on equity, it attracts the attention of other firms who move into the same industry. The existing entrenched firms in the industry undercut the new firm's prices. As all firms respond to these competitive threats with price cuts of their own, profitability suffers driving down ROE for the entire industry.
This is what is happening to technology now. However, unlike other industries, the share prices have not come down to reflect the new realities of the industry. Instead, institutional investors and momentum traders are bidding up the shares of these companies without a meaningful due diligence of the industry. They are acting like this is 1991 and another technology boom is upon us when none actually exists. Microsoft's monopoly of operating systems is coming under attack from Linux. Intel's lead in chip technology is coming under attack from AMD whose 64-bit Hammer chip is far superior to Intel's Pentium dynasty chips.
It isn't just that Intel and Microsoft are coming under stiff competition. Both firm's business models are maturing. Microsoft is no longer growing its business at a compound rate of over 40% nor is Intel. Yet if you look at today's market price for these two companies, they are selling at earnings multiples reflective of the early boom days in technology. There is clearly a disconnect between today's market price for technology stocks and the underlying fundamentals of the industry. Applied Materials' sales growth has gone virtually nowhere in the last three years. Stockholders equity at Intel is virtually flat over the last three years as the company has used profit to buy back shares to prevent dilution from stock options. Motorola's balance sheet is hemorrhaging; while Texas Instruments' shareholder equity is about where it was four years ago. Yet, that is exactly as it should be in the midst of a bubble. That is exactly where we are today. This is nothing more than a repeat of the 1999 mania all over again. However, this time investors' in particular the institutions who have fiduciary responsibility for managing other peoples' money should know better.
The Bubble is Back in the Internet Sector Too
If things are out of whack in the semiconductor industry, they are even more ludicrous in the Internet sector. A look at Amazon.com and the retailing sector is a prime example of this absurdity. Amazon is up 215% this year. A look at Amazon and its closest competitors is very insightful. The following table reflects this absurdity and shows just how ridiculous investors are getting again.
Table 7: SALES & NET INCOME COMPARISON (millions)
1998 to 2003
|Barnes & Noble||$3,005||$3,386||$4,376||$4,870||$5,269|
|Sales Net Income|
Amazon is still losing money; while its competitors are earning a profit. Can intelligent investors be valuing the Amazon franchise 12-15 times more than its closest competition? It gets more absurd if you compare Amazon to other brick and mortar retailers. Costco had over $42 billion in sales last year and earned a profit of $721 million. Yet it’s market cap is $8 billion less than Amazon's. Other retailers with much higher sales volume, bigger profits, better operating margins and returns on capital are valued at even lower market caps. Compare Federated, May Company and Sears by comparison. Can a company that earns no profit really be worth 5-14 times more than its competitors?
Table 7: RETAILER COMPARISON
|Company||Market Cap||Annual Sales||Annual Profits||Operating Margin||Return on Capital||Recent
|Barnes & Noble||$1,927||%5,269||$100||5.49%||9.35%||29|
|J. C. Penney||$6,791||$32,347||$405||3.29%||6.41%||25|
It is obvious whether you look at the SOX, the Internet, or the NASDAQ that the bubble is back. Investors are making the same mistakes that they did in 1999-2000. The media tells us that they are smarter this time having learned their lessons from the past. Oh, really! What I believe will happen this time is that institutions have joined individual investors bidding up the shares of speculative stocks in order to increase performance. This time around when trouble starts to surface, the real lesson learned from the past is that no investor will stick around when the first signs of trouble surfaces. This means that everyone will head for the exit gates at the same time. That will be a sight to behold. In the meantime, Eric King's charts are also telling a story.
by Eric King
Applied Materials: Chart 1
I am opening up this section with Applied Materials because of the inventory buildup they are experiencing. The following 10-year weekly chart of AMAT (Applied Materials) shows the stock running into resistance around current price levels. The 250-week moving average had acted as support in 1996 and during the Asian crisis of 1998. The 250-week average also acted as support in late 2000 and early 2001. The weekly average is currently acting as strong resistance on the upside as seen on the right hand side of the chart.
Applied Materials: Chart 2
The following AMAT 10-year monthly chart shows the monthly moving average supportive in 1996 and 1998 as well. This monthly moving average was also supportive in late 2000 and early 2001. The monthly moving average is now acting as strong resistance, as shown on the right hand side of the chart. Note recently the stochastics have crossed into a "sell" signal, possibly indicating a top.
Applied Materials: Chart 3
The AMAT quarterly chart shows the 20-quarter moving average acting as support in 1996, 1998, and also late 2000 and early 2001 as well. The 20 quarter average is now acting as resistance. Note the separation between the MACD and the signal line has narrowed considerably after becoming extremely oversold. I believe the MACD is now ready to roll over and continue in a "sell" signal. The RSI has been wobbling around the 50 line with no conviction during this latest rally.
Intel Corporation: Chart 1
Moving on to Intel (INTC), we see the 200 weekly moving average acting as strong resistance on this chart. Recently INTC bounced off of the 200 weekly moving average once again.
Intel Corporation: Chart 2
The INTC 50 monthly average has acted as strong resistance since early 2001 and the stochastics appear to have peaked as well, possibly indicating a top.
Intel Corporation: Chart 3
INTC also had difficulty with the 20 quarter moving average and the stochastics look toppy as well.
Philadelphia Semiconductor Index (SOX)
Monthly, 5-Year Chart
The following 5-year monthly chart of the SOX (Semi Index) shows the monthly moving average was supportive in late 1998 and also in 2000 and 2001. In late 2002, this monthly moving average began to act as strong resistance and continues to act as resistance as shown on the right hand side of the chart. Throughout this rally, the RSI action has been less than impressive and the stochastics look toppy as well.
Bull & Bear Sentiment
The following weekly sentiment chart derived from Investor's Intelligence numbers shows the tremendous separation between bullish vs. bearish advisors and is a huge red flag for this rally not only in the SOX, but in the stock market as well.
Bull Minus Bear / S&P 500 Index
The following weekly sentiment chart shows the stock market tanking each time the separation between bullish vs. bearish advisors becomes too stretched. Recently the bullish advisors have significantly outnumbered the bearish advisors by the largest spread of the entire bear market, yet despite this fact the stock market has plodded higher. The action of the stock market and the bull/bear numbers is very reminiscent of 1987, prior to the stock market crash.
It should also be noted that the latest AAII Index readings showed 60.3% bulls and only 13.8% bears.
"The public preference for stock is not only as marked as ever, but also the will to speculate is still a speculative factor not to be overlooked. The prompt return of huge speculation and the liberal manner in which earnings are being discounted indicate that it will be difficult to quench the fires of stock market enthusiasm for long." Barron's, March 24, 1930 issue.
The mania is alive and well and the public is being suckered in once again just like they were in 1930, this most likely signals a top in this secular bear market rally. There was nothing from an economic or value perspective to support the rally in stocks in 1930 and this article clearly demonstrates the same can be said of the rally in the stock market today.
Watch out below!
© 2003 Jim
Puplava & Eric King
October 20, 2003
Charts courtesy of: www.bigcharts.com and VTO
© 2003 James Puplava