NEW YORK (CNN/Money) -
Anybody who paid the slightest bit of attention in their high school physics classes should remember this old axiom: What goes up must come down. Or to quote rock group Radiohead, "Gravity always wins."
Tech investors know this all too well.
Shares of Cisco Systems, the leading maker of networking equipment, fell nearly 5 percent on Thursday. That follows a more than 40 percent rise in the past month, even though there was no real news to support the runup. Now there is news. And it is bad.
On Wednesday evening, Cisco CEO John Chambers confirmed that the tech-spending outlook wasn't improving. Although Cisco beat earnings expectations for its fiscal third quarter (which ended in October), it warned that sales for its next quarter might be lower than the $4.85 billion it just posted. This helped pull the Nasdaq down 3 percent on Thursday and could be the beginning of another sharp drop for tech.
The Nasdaq had run up more than 27 percent between Oct. 9 and Nov. 6. But many attributed the buying binge to mutual fund managers chasing momentum to try and boost fourth quarter results. Now that there is some bad news, these managers might start heading for the exits.
"Institutional investors almost panicked themselves into buying tech shares because they were underperforming their peers. In this world if you underperform your peers for two or three weeks, you're a dead man," says Bert Hochfeld, managing director of Montauk Capital Markets, a firm that provides research to institutional clients.
To that end, Wendell Perkins, manager of the JohnsonFamily Small Cap Value and JohnsonFamily Large Cap Value funds, says that he bought shares of chip company Verian Semiconductor in early October and sold it after the stock ran up 80 percent. Johnson said he also sold telecom equipment company Tellabs, which went from a low of about $4 in late September to briefly above $10 on Nov. 4.
"When you have stocks that are doubling in value in a few weeks when there's no significant change in fundamentals, that's all you can hope for. It's not worth hanging onto any longer," Perkins says.
Poor fundamentals + rich valuations = sell
Cisco's results are troubling for a couple of reasons. The fourth quarter is typically the strongest for tech as companies rush to buy before year-end and new budgets kick in. So the fact that Cisco's sales might fall in this quarter is truly a bad sign.
| * From Oct. 9 through Nov. 6 ** For current quarter during the past month | | Sources: FirstCall, CNN/Money |
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Plus Cisco, unlike struggling rivals Lucent and Nortel, has major exposure to corporations in a variety of industries. Only about 25 percent of Cisco's revenues come from telecoms so Cisco's results truly show how bleak the overall corporate spending environment is.
Michael Davies, analyst with Caris & Co, a research boutique that does no investment banking, says tech stocks have gotten ahead of themselves and that valuations are once again too high. If fundamentals were improving, he says techs might be able to support higher valuations. But there's still no sign of that.
Davies owns Cisco but says he would not be buying here, with the stock trading at about 24 times fiscal 2003 earnings estimates and 4.5 times projected sales. Sales for fiscal 2003 are only expected to increase 5 percent from fiscal 2002. "Show me something a little bit better and tech stocks would warrant a higher multiple. Right now it's as good as it gets and that's reflected in the prices," he says.
Leaders safe for long haul but don't expect much in the short-run
To its credit, Cisco reported a big gain in gross margins in the third quarter and was able to beat earnings expectations by a penny. And Hochfeld says that he wouldn't be surprised if Cisco beats current estimates of 13 cents a share for its fiscal fourth quarter either because it has proven that it can gain market share and keep a hold on expenses during tough times.
So if you want to take a gamble on tech and you have a long-term horizon (i.e. you can stomach a likely pullback in the near-term) then large cap market leading tech companies are the way to go, says Andrew Pratt, manager of the Montgomery U.S. Focus and Montgomery Growth funds. He owns Cisco, Microsoft, Intel and IBM.
"My strategy is to stay with companies that are executing well despite the negative tech backdrop. At some point tech is going to recover and these are the companies you'll want to be in," Pratt says.
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But smaller tech companies still look extremely risky. Hochfeld says that Cisco's bad news might spur analysts to cut estimates for companies like communications chip manufacturers PMC-Sierra and Applied Micro Circuits, for example.
So if you hopped on board the tech train in October with hopes that the rally was for real it might be time to take some money off the table. That's what the pros are doing. Perkins says the only reason techs weren't falling even more on Thursday was the lingering positive effects of the Fed's 50-basis-point rate cut on Wednesday. And he thinks the market will drift back towards its October lows once the Fed-induced euphoria subsides.
"What you've seen out there is nutty. It doesn't make any sense," Perkins says.
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