SOCIAL TOPICS (Archive): INVESTMENT & ECONOMIC ANALYSIS

Published, Summer 2001

       Over the past year, much of the information technology (tech) sector has experienced a flight worthy of Icarus: first soaring dangerously high, only to crash and burn. Investment sentiment has gone from the optimistic “the Internet will change everything,” to the cynical “the new economy was a myth.” In 1997, technology represented about 18 percent of the S&P 500; by early 2000, it peaked at 35 percent. As of now, technology is about 20 percent of the market.

       There were two major trends that led to explosive growth in tech stocks in 1998,1999, and early 2000: the excitement over growth prospects for dotcoms and the dramatic increase in the number of upstart phone companies. In 2000, sales and earnings growth for technology companies averaged 20 percent and 31 percent, respectively. In spite of the lack of a well-defined path to profitability, assumptions were made by venture capitalists and Wall Street investment bankers that created a sense of urgency to get in on the ground floor of these great trends. By the latter half of 2000, however, rising interest rates combined with the growing realization that many dotcoms’ business plans didn’t make sense even over the long run caused investors to turn away. Meanwhile, phone companies had to reduce their capital spending plans to make up for their own lack of profitability. The smaller phone companies ended up going out of business, while the larger firms like AT&T and Worldcom had spent so much money trying to compete that they needed to pull back their own equipment purchasing. Still another reason for the tech slowdown was the end of the Y2K spending bubble on computer goods and services for both companies and consumers.

       In 2001, sales growth is expected to average about 7 percent, and earnings are likely to drop almost 14 percent. The operating expenses of these capital-intensive companies are fixed over the short term, meaning that when revenues are lower than expected, their margins (profits as a percent of sales) decline sharply. Whether margins will return to their previous high levels when revenues expand again is questionable. Competition is expected to remain intense, putting pressure on pricing and thus on margins. This is likely to continue until research creates new products with competitive advantages that allow leading companies to charge higher prices, or until companies lower their costs to the point where they can make money with the existing level of sales.

       Where are we now? As of June, technology companies are reporting few signs of the downturn ending. Many are claiming that business has bottomed or will bottom in the next quarter or two, but they have little data to back this up. Technology suppliers are hoping that interest rate cuts will fuel an upturn in capital spending, but this will take time. Because technology stocks move so quickly and tend to anticipate fundamentals, investors haven’t sold these stocks to anywhere near previous trough levels of valuation. Thus, by several measures, many of them continue to appear expensive.

       In spite of its volatility, information technology is an important investment sector for social investors. It will continue to be a leading growth engine of the economy: Today technology represents over half of capital equipment spending and is credited with about two-thirds of the doubling of productivity growth improvement from the first half of the 1990s to the second half. Technology companies create opportunities for improvement in the quality of life on a global scale. In addition, because of their need to attract special skills and their growth rates, tech companies tend to be more progressive in their employment policies. Social investors have benefited in the past from having technology stocks as part of a diversified portfolio, and they will do so in the future as well.