Glamour tech stock values not tempting

By Norm Rothery on January 29, 2014
Estimated reading time: 4 minutes

Enticed by popular cloud or social media stocks? Only 11 U.S. software firms of 129 screened trade under 20 times earnings.

(Image courtesy of ddpavumba / FreeDigitalPhotos.net)

Marshmallows have been on my mind and it’s not due to a New Year’s resolution to cut back on sweets. The treats feature prominently in a series of fiendish experiments conducted on young children. In them a child is led into a room, put into a chair, and presented with a devilish choice. A marshmallow is placed on the table. They can choose to eat it immediately, or if they wait 15 minutes without indulging, they’re promised a second one. Then they are left alone with the treat to decide. You can see videos of the experiment in action on YouTube by searching for “marshmallow experiment.” You’ll see the kids squirm in their chairs as they try to resist the urge to wolf down the treat. Many succumb to the temptation before the 15 minutes elapse. But it’s not just children who have a hard time delaying gratification. Some of us continue to eat too much and others spend more than they earn. When it comes to the stock market, glamour stocks are much like marshmallows. They’re exciting, fired with rosy growth prospects, and offer the dream of riches. While they might provide a speculative sugar rush, their long-term prospects tend to be quite poor. A friend is, unfortunately, enamoured by glamour technology stocks. It’s strange because he’s an excellent saver and generally has sound instincts about most financial matters. But his love of new technologies and exciting businesses leads him astray from time to time. These days he’s keen on social media firms like Twitter and asked my opinion. Since I don’t usually bother with such stocks, I decided to take a step back to look at the industry more generally. I began by collecting data on U.S. software stocks with market capitalizations in excess of $100 million. According to Bloomberg, 129 firms fit the bill. They range from well-known companies like Google, Microsoft and Oracle, down to tiny firms just starting out. The full list is available here, but a quick scan reveals it’s an unpromising source of ideas for frugal investors. Only 61% managed to earn a profit last year. Even worse, a mere 11 can be purchased for less than 20 times earnings: a classic cut-off for value investors. But it’s not just earnings that are out of whack. Only 21 of the 129 trade at price-to-sales ratios of less than 2. At the other end of the spectrum, 19 trade over 10 times sales and 13 of those haven’t earned a dime in the last year. How does Twitter (TWTR) fit into this picture? It’s one of the worst offenders. The company, based in San Francisco, trades at an astounding 74 times sales and it’s burning through cash. Current results are one thing but Twitter’s shareholders are clearly looking to the future. They’re willing to pay a very high price today in the expectation the company will grow significantly and earn pots of cash in the future. Analysts certainly expect a great deal from it. They believe it may become profitable in 2016 and earn roughly $800 million in 2018. Problem is, based on current prices, that puts its far-forward price-to-earnings ratio at a still sizable 40. Simply put, I’m not interested in buying Twitter’s stock at current prices. That’s not to say the company is doomed. Far from it. It provides a useful service that’s wildly popular and one I personally enjoy. So the company should do well in the short term. But its stock has gotten well ahead of itself. Only a few software firms trade at reasonable relative values, including Oracle (ORCL) and CA Technologies (CA). Among the best is one of the biggest stocks in the world. I’m talking about Microsoft (MSFT), well known for its Windows operating system, Office software, and gaming consoles. The firm, based in Redmond, WA, is a less than glamourous mature company that has attracted the attention of some notable value investors. Consider how Microsoft measures up on valuation. It trades at 3.7 times sales, 13 times earnings, and 10 times cash flow. Dividend investors will also appreciate its dividend growth record and its current dividend yield of 3.2%. In addition, the firm is sitting on a pile of cash. Even if it paid off all its liabilities (without tax consequences), it would still have about $5.85 per share in cash and investments leftover. Problem is, no one expects Microsoft to grow at a rapid rate. If anything, its business is under pressure from the Googles and Apples of the world. Still, analysts expect it to grow at a modest rate. The combination of growth and a cheap price works wonders—particularly if a firm exceeds the market’s modest expectations. While Microsoft isn’t quite as cheap as a skinflint like myself might like, I’d much rather own it than Twitter. Alas, glamour stocks tempt far too many investors. Like marshmallows, they promise a speculative lift in the short term but they have a disconcerting tendency of melting away in the long run. Norm Rothery, CFA, PhD, is the founder of StingyInvestor.com