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Subject:  The Problem With Technology Date:  1/28/2007  6:13 PM
Author:  mhirschey Number:  127037 of 236393

Buffett is fond of saying, "I don't understand technology." I smile when I hear him say that because I know that he is sandbagging the listener. Buffett studies all forms of business, and knows how difficult it is for technology-based comapnies to maintain a real competitive advantage. What Buffett is saying to the informed listener is "I don't understand how technology-based companies can now expect to build durable competitive advantage when none have been able to do so during the entire mondern era of the stock market."

Case in point: The Nifty 50 of the 1970s. The Nifty 50 was a group of 50 premier growth stocks that became stock-market darlings during the early 1970s. At the market peak in 1972, the group of Nifty 50 stocks sold at a P/E ratio of 41.9:1, or more than double the market average of 18.1:1. Each of these stocks had proven growth in revenues, earnings and dividends. Virtually none had experienced a dividend cut during the post-World War II period. All had sufficiently large market capitalizations to allow large institutional investors to buy as much of them as their portfolios could hold. They represented the ultimate in one-decision stock investing. An investor simply had to buy and hold. No matter how high Nifty 50 stock prices seemed relative to revenue, earnings, or any other fundamental factors, any perception of being overvalued was sure to be temporary. Superior rates of growth would bail out any buyer, no matter how high the price seemed at the time of purchase. Nifty 50 investors could not lose, or so the story went, until the vicious bear market of 1972-74.

From a bull market peak of 1036.27 on December 11, 1972, the DJIA crashed to 577.60 on December 6, 1974. This bone-chilling drop of 44.3% for the market was relatively mild when compared with the devastation suffered by “Nifty 50" darlings. Coca-Cola dove 66.9% from 149 3/4 to 49 5/8, Disney cascaded down 91.3% from 236 3/4 to 20 ½, Eastman Kodak tumbled 58.9% from 149 1/4 to 61 1/4, McDonald's plunged 63.2% from 77 3/8 to 28 1/2, while Phillip Morris plummeted 59.4% from 118 1/4 to 45. The devastation experienced by stockholders of these Nifty 50 companies does not represent the worst of the story. Although some are no longer considered great growth stocks, all have continued as successful pillars of corporate America. All are now members of the DJIA. Some other former Nifty 50 companies and their shareholders did not fare as well. Former Nifty 50 companies, such as Burroughs, Digital Equipment, Joseph Schlitz Brewing, and MGIC Investment are gone. Their status as “bullet proof” growth stocks not only failed to protect them from disturbing volatility in a full-fledged bear market, for them it was down and out.

The plunge in prices for the original Nifty 50 during the severe bear market correction of 1972-74 has long been viewed as just punishment for absurdly valued stocks and the naive investors willing to buy them. Until recently, no one rose to defend such excesses. No one, that is, until Jeremy Siegel, a professor of finance at the University of Pennsylvania's Wharton School, became part of the Nifty 50 story in 1994 when he published an eminently readable book on the stock market titled Stocks for the Long Run. In his book, Siegel laid out a bullish argument for equity investing and calculated that an investor paying top dollar for the Nifty 50 in late 1972 would have earned nearly the same returns over the next 25 years as someone holding the S&P 500. Siegel calculated that the original Nifty 50 produced a 12.5% annualized return, slightly behind the 12.7% for the S&P 500. "Good growth stocks are expensive, but they can be worth the price," said Siegel.

Siegel's book added fuel to the firestorm of controversy surrounding valuations of the 1990s version of the Nifty 50, the high-flying high-tech stocks, especially those tied to the Internet. When asked what he thought of the new Nifty 50, Siegel hedged. The notion that good growth companies can be worth more than 50 times earnings has been proven by the facts. Siegel's book showed the "warranted" P/E of the original Nifty 50, using a stock price then that would result in a return equal to the S&P 500 over the ensuing 25 plus years. Coca-Cola, for example, traded for a P/E of 46.4:1 in late 1972 but was actually worth a P/E of 82.3:1 given its market-beating results since then. That being said, it is clear that some of the best performances turned in by former Nifty 50 stocks have been generated by lower-multiple consumer products companies, such as Gillette, Pfizer and Philip Morris. Nearly all the superhigh P/E stocks lagged behind, including Avon, International Flavor & Fragrances, and Polaroid. Siegel proclaims that only a handful of the best growth stocks in the past has been worth more than 70 times earnings. Microsoft is one stock that could well live up to its lofty P/E of 70 in 2000, yet it is worth remembering that IBM was once thought to be invincible. Of course, that was when Microsoft was a baby.

Nobody now believes that anyone will oust Microsoft from its domianance of the computer desktop. However the game has changed. Internet-based communication depends less upon desktop-based software, and more upon search and other Internet-based applications. I'd guess that's why Microsoft is so worried about Google. I'd also guess that the super-smart folks at Microsoft will help the company avoid the fate "enjoyed" by Burroughs and Digital Equipment, but their existence, let alone investment success over the next 20 years, is far from assurred. On the other hand, I'm quite sure I'll be buying Dilly bars on the Fourth of July at the Nisswa, Minnesota Dairy Queen in 20 years, God willing.

Next time you enjoy a Dilly bar or sip a Bud, please have the sensibility to smile when someone suggests that Buffett just doesn't understand technology.


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