The oddsmaker's art


CNET News staff
7 min read
Intel (INTC) had every reason to feel confident.

The giant chip maker last month was all set to post its fourth-quarter and end-of-year earnings. While the world didn't know it yet, top-level financial chiefs inside the company knew that Intel would declare numbers that would once again mark Intel as one of the single most powerful and succesful companies in the PC industry.

Despite a worldwide downturn in the PC market during the critical Christmas season, despite price cuts across its product lines, and despite the expenses of launching its MMX chip technology, the company would soon be rich enough to offer its employees $820 million in cash bonuses, profit sharing, and retirement pay for 1996. That's more in benefits than the company actually earned in total revenues in 1981 and about as much as it posted in profit in 1991.

The trading floor at the Pacific Stock Exchange

One might have thought that this would have been good news for any investor with Intel in his or her portfolio. But it wasn't good enough for Wall Street.

The company announced its results after the market's close on January 14, beating analysts' estimates on every measure by a wide margin.

Yet the next day, the company saw its stock fall 4-7/8 during a day of feverish trading, closing at 142-1/4. That same day, several analysts rushed to downgrade their stock ratings for Intel, decisions that kept the stock slipping for several days.

Intel is an investor in CNET: The Computer Network.

Was it something Intel said?

In fact, company CFO Andy Bryant did say something that spooked investors. He warned them that they should expect the first quarter to slow down a bit.

Historically speaking, this shouldn't have been a surprise: Intel's first quarter is usually slower than the fourth quarter for the obvious and predictable reason that the Christmas buying season is over.

But the news scared Wall Street, not just about Intel's short-term expectations but also about the high-tech industry overall. After all, if Intel doesn't think it can keep it up, then who can? Over the course of the next several weeks, several of the biggest companies in the industry would be hit by the same phenomenon.

IBM (IBM) beat analysts' expectations, too, but its stock lost 10 points the day after it announced its earnings. The industry segment that was hit hardest was networking, a market that seems to have found a golden goose in the Internet.

That's just how it is in the high-tech stock market, where the dollar you might make tomorrow is more important than the dollar you already made today.

"Technology stocks are certainly more volatile than any other group," said Peter Canelo, chief investment strategist with Dean Witter. "They have superior earnings growth, and when the earnings don't grow the stocks get trashed."

High-flying tech companies that have seen their stock price quickly soar can just as quickly lose favor with Wall Street. Why? Because investors rely on high-tech for the high-growth slice of their portfolio. If high-tech stabilizes and becomes a solid, profitable, but slow-moving industry, then what will Wall Street do for short-term gains?

In an investor's mind, the role of high-tech is to make money quickly, as it has done for most of the 20-plus years of the PC industry. But as that industry matures into a bigger piece of the overall economy, Wall Street is starting to be afraid that high-tech just can't keep it up forever.

That's what happened to Intel this past quarter. "A lot of the Wall Street guys said it can't get any better and took their profits," said Howard High, an Intel spokesman. (Intel is an investor in CNET: The Computer Network.)

Such is the game in high-tech, where the rules are different from any other segment of the economy. Figuring out whether those rules will result in winnings or losses for investors is the job of stock analysts.

"helvetica"=""> Rule #1: There really aren't any rules.
High-tech stocks are essentially unpredictable. Investors expect high returns and they've generally gotten them, but only by enduring a constant roller-coaster ride of volatility compared with other industries, such as the automotive industry or banking.

The reward for surviving the ride is growth. Over the past five years, technology stocks have risen or fallen 14.2 percent on the overall market's rise of 10 percent.

Playing the game means bracing for fast, hard market swings, and the rest of the rules give some clues as to which direction they are likely to go.

"helvetica"=""> Rule #2: The high-tech economy operates on product cycles rather than economic cycles.
The behavior of many large industries can be linked to general trends in the economy like unemployment or the overall growth of the economy. But high-tech is largely divorced from such variations in the macro-economy. Instead, it's tied to the fast development cycles of the products themselves: chips that double in speed every 18 months and software that is cutting-edge one year and obsolete the next.

"Most people invest in technology because they want to invest in a product cycle or a technology cycle...much more so than they think of the economy," said John Rohal, managing research director for Robertson Stephens. "Whereas with retail, the old rule was you buy retail stocks when interest rates are dropping and sell them when interest rates are rising."

The automotive industry is also a cyclical market where new products replace older ones every year, but its companies have an established franchise, or market share, to weather tough times. But investors can't be sure of the strength of the franchise itself in the technology market, according to Michael Kwatinetz, head of technology research at Deutsche Morgan Grenfell.

Kwatinetz on tech stocks vs. other industries; footage of the Pacific Stock Exchange
The Internet is the most recent example of this. When Netscape Communications (NSCP) went public and its value more than quadrupled in five months, investors jumped on Internet companies in the hopes that anything Internet-related was part of a bankable franchise.

But now, 2-1/2 years later, Netscape remains one of the few Internet companies to have proven itself, while companies like the search engines Infoseek (SEEK) and Excite (XCIT) are still struggling to establish that the Net is profitable for them.

"helvetica"=""> Rule #3: These high-tech product cycles are unique to each company or group of direct competitors.
"Many times, people try to categorize the whole area as technology, but in fact the dynamics are very different from sector to sector," Rohal said.

Not just every segment of the industry, but even each individual company reflects unique variations that high-tech stock analysts must understand if they are to guess right about where the stock will be headed.

"Price drops are at times kind of scary to investors because they have to figure out the meaning of that price drop," Kwatinetz said. "When Kellogg's dropped cereal prices, it was forced to because it had raised them too much and customers had started to object. But when Compaq Computer (CPQ) announces a price drop, Wall Street has to figure out if this is just business as usual, or does this really mean there's a problem. That's a very different scenario from traditional companies."

"helvetica"=""> Rule #4: You can't count on what the company says.
Like any industry, stock analysts are in part basing their stock picks on what they expect a company to produce in a given quarter. But in high-tech, especially software, product delays are not the exception but the rule. While everyone knows this, stock analysts are still likely to punish a company that misses its deadlines because it ruins their calculations.

Octel Communications (OCTL), for example, saw its stock plummet 35 percent after it announced its Unified Messenger upgrade product would be delayed by six months. Its shares fell to 15-3/4, down 8-3/4 after the news.

"Wall Street treated our stock unfairly. It was a software delay that didn't affect our profitability in the long-term, but it cut our market value in half," said Greg Klaben, Octel's director of investor relations. "It was representative of the very short-term view of the marketplace."

"helvetica"=""> Rule #5: High price-to-earnings ratios are good until they get too high.
Price-to-earnings (P/E) ratios, or multiples, represent a company's earnings per share for its last four quarters divided by its share price and serve as a barometor of how expensive or cheap a stock would be to buy. High P/E ratios indicate investors believe the companies are capable of high growth. Netscape, for example, currently has a P/E ratio of 184.87. But when the ratio gets too high, the company is at greater risk for a correction.

"Eventually you have to assume that these companies can't keep on outgrowing the economy forever," said Deutsche Morgan's Kwatinetz. "What is implicit in those multiples is that the growth has to be just huge in order to justify those multiples."

"helvetica"=""> Rule #6: Same as #1. There are no rules.
"Technology is the only part of the economy that is showing substantial growth," said Michael Murphy, editor of the California Technology Stock Letter and NEWS.COM guest columnist. "And new growth areas are always more volatile as they attract speculative money at first...High-growth stocks are sensitive to small changes in what people's outlook on what the future will bring."

The question moving forward is whether these rules will stay the same over the long haul, dictated by an industry that is inherently fast-paced and constantly changing. Or if, as the market for personal computers becomes saturated, as some have predicted, that the growth of the whole industry will slow down and the stakes become significantly less interesting for high-tech gamblers on Wall Street.

Photos by Margaret Lee, CNET

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