Technology > Tech Investor
The meek shall inherit the worth?
Small-cap techs trade at a big premium to the industry's giants. It won't stay that way forever.
June 26, 2003: 2:59 PM EDT
By Paul R. La Monica, CNN/Money Senior Writer

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NEW YORK (CNN/Money) - Do you like your tech stocks BIG or small? These days, the market is fawning over tiny techs.

Just look at the numbers. The 25 biggest tech stocks (excluding foreign companies listed as ADRs), companies with a market value of at least $10 billion, are trading at an average multiple of 29 times 2004 earnings estimates. But the 337 small-caps, companies with a market value between $200 million and $1.5 billion, are trading at 39 times 2004 earnings projections.

Now on one hand, this 35 percent premium for small caps appears to be quite justified.

After all, the small caps are expected to post a mean (as in average, not surly) profit increase of 96 percent in 2004 and 21 percent gains annually over the next three to five years.

The tech behemoths are only expected to post earnings increases of 46 percent next year and 16 percent over the long haul.

But there are a lot of plausible "what if" scenarios out there that make this premium seem just a bit extreme.

What if earnings estimates are too high? If the economy does not bounce back as sharply as investors are hoping for and companies continue to keep a white-knuckled death grip on IT purse strings, then look out below.

David vs. Goliath
Smaller techs are trading at a premium to industry giants and their growth rates are higher. But how long can that last?
Small-capsLarge caps
P/E (2004 est.)39.428.8
YTD price change45.2%28%
2004 Est. EPS Gr.96%46%
Long-Term Est. EPS Gr.21%16%
* Small caps have market values between $200 million and $1.5 billion. Large caps have market values above $10 billion. All data as of June 25

Big techs certainly wouldn't be immune from a pullback but momentum stocks with pricey valuations typically fall even harder if they disappoint Wall Street. Or have you forgotten 2000, 2001, and 2002 already?

What if consolidation continues? Sure, the companies that wind up getting bought by the industry giants could receive some nice premiums (although Oracle's first low-ball bid for PeopleSoft indicates otherwise). But what happens to the companies that don't get acquired and now have to compete against even larger rivals?

Is it wise to pay a huge premium for say, a software company that could be easily crushed by the likes of Microsoft and IBM? Have you looked at the five-year stock charts of Corel (CORL: Research, Estimates) and Novell (NOVL: Research, Estimates) lately?

And finally...

What if more tech leviathans decide to follow Oracle CEO Larry Ellison's lead and use their strong balance sheets as a weapon?

Even if Oracle doesn't buy PeopleSoft, it appears that PeopleSoft will suffer. Analysts widely expect its second quarter, which wasn't supposed to be that stellar to begin with, to now be a total mess due to the uncertainty that Oracle's bid is creating in the application software marketplace.

The 25 largest tech companies clearly have the wherewithal to launch Oracle-like bids of their own, with a total of nearly $200 billion in cash and investments on their balance sheets as of the end of their most recent quarter. (Granted, Microsoft accounted for $59.2 billion of this sum.)

No niche too small for large caps

Simply put, investors making a big gamble on small caps are betting that tech is due for another huge wave of prosperity and that the established leaders are going the way of the dodo. These investors appear to be in denial.

Pip Coburn, global technology strategist for UBS Warburg, said that he does not see a proverbial next big thing, no catalyst to spark another massive wave of technology spending.

So companies like Microsoft and Cisco Systems would probably be interested in any growth they can get. Instead of treating niches like so many crumbs left on the floor, the giants will be aggressively fighting for smaller market segments.

How else to explain Cisco' s purchase of Linksys to get into the home networking market, Microsoft's recent decision to buy a Romanian anti-virus software firm and on Thursday, Sun Microsystems' acquisition of Pixo, a software firm that helps manage distribution of content such as games and ringtones to wireless devices?

"There will be maybe ten companies having their finger on the pulse of everything. Going forward that will make it more difficult for specialized companies," said Coburn.

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This is not to say that investors should ignore all small companies. Of course, innovation will continue and that will create opportunities for upstarts. But investors should be selective and not make blanket wagers on small caps because there probably isn't going to be another tech gold rush anytime soon.

"Tech investors haven't fully accepted that the industry is maturing," said Coburn. "The market is hoping and praying that we're still in the late 90's."

A quick look at the calendar and the level of the Nasdaq clearly indicates that's no longer the case.

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