Large technology stocks: hype or reality?

Investors are betting on the rosy future of technology and paying high prices for Internet-related stocks, but technological change is so rapid and so nearly random that counting on the future is more of a gamble than an investment.

Apparently, you are less likely to lose--or at least you can feel less anxiety--if you bet on a large company like Cisco or BEA Systems than on a small technology company that has yet to prove its technology and business model are viable in the marketplace.

Because professional institutional investors such as technology-oriented mutual fund managers know this, they have been buying primarily the large tech stocks like Cisco and AOL. But, in truth, it is extremely difficult for even companies such as these to maintain the degree of dominance that might justify the market valuations of most large-cap tech companies.

Nine out of every $10 of venture capital was pumped into technology companies in 1999. Over half of all venture capital was invested in Internet-related activities, according to PricewaterhouseCoopers. This is an amazing statistic considering that the Internet was barely on anyone's commercial radar screen a mere 5 years ago. In addition, much of the venture firms' investment activity, although not directly Internet-related, has been in corporations such as telecom software enterprises and enterprise resource planning (ERP) companies that use the Internet as a significant enabling technology for their businesses.

Commerce One and over 20 of the world's major corporations and online marketplaces recently have formed the Global Trading Web Association, the first commercial organization focused on the development and expansion of international business-to-business (B2B) e-commerce. No one can accurately predict the individual corporate outcomes from such a bleeding-edge endeavor.

Meanwhile, business-to-consumer (B2C) companies have proliferated beyond counting. Even the most visible business-to-consumer companies, like Amazon.com, are having trouble proving their business model works. The big question is whether these companies can turn cash flow positive before they run out of money and additional sources of funding. Generally, the largest expense for these companies is sales and marketing as they spend millions trying to increase awareness of their presence and benefits--in a word, as they try to gather customers.

Companies have to perform well for a long time before they can provide attractive payoffs to investors. Companies that provide infrastructure for the Internet, like Cisco Systems, have begun to gain a certain ascendancy over companies like Microsoft. Microsoft has dominated the client-server desktop with its Windows operating system and applications like Excel that run on that operating system.

Consumers, or at a minimum the millions of business-user consumers, do not each need their own copy of Excel. They can, instead, simply access Excel or its functional equivalent from the server (central computer), and store their working files on the network. In the centralized server environment, industrial-strength operating systems like Unix have advantages over Windows, and big database systems like those from Oracle compete strongly against Microsoft's SQL Server relational database management system.

Microsoft's shares have fallen into deep disfavor this year, while Cisco's have continued to move up strongly. It's almost as though Microsoft has been relegated to the "old economy" scrap heap, despite its relatively recent vintage. So, rapid negative change can befall even huge companies, and yet this type of stock continues to dominate the market averages.

This means that the class of stocks that traditionally has provided the highest long-run returns--small capitalization value stocks, and secondly small cap growth stocks--largely has been ignored for the last 3 to 5 years. For example, large-cap growth stocks returned 34 percent annually for the 3 years ended December 1998, while small-cap growth stocks returned only 10.4 percent. This imbalance was even more extreme at the end of 1999.

A feedback loop seems to have been established, such that huge amounts of money began chasing past performance on the part of a relatively few large tech stocks. I agree with the conclusions reached in a paper published in the July/August Financial Analysts Journal ("New Paradigm or Same Old Hype in Equity Investing?"), in that I believe this is the result of an institutional investor behavioral pattern--rather than fundamental operating performance.

One response might be to shift more of one's investment portfolio toward stocks or funds that focus on less-richly valued small cap growth and value funds.