Nowhere to Go but Down?

Pleasantly Surprised
The Wall Street Journal had a frightening graphic following the news of Steve Ballmer's exit from  Microsoft (MSFT). Frightening, that is, from the perspective of anybody invested in the nation's largest technology companies. The five biggest tech stocks as of January 2000 bombed. Only  International Business Machines (IBM) managed to retain its share value--just barely. The other four have each dropped at least 50% in price. 

Which got me wondering: Is long-term failure the inevitable result when investing in the biggest technology companies? Perhaps the nature of technology product cycles is that when a company leads its industry, the best future hope it can have is to hold its competitors at bay and tread water. More likely, it will lose ground altogether, as its outdated products are replaced by those of a newcomer that isn't burdened by legacy issues.

That was my hypothesis--and it was wrong.

The reality is quite different than suggested by The Journal's chart. For one, the starting point of January 2000 is distorting, occurring as it did at the peak of history's largest tech-stock bubble. That's not the paper's fault, as January 2000 happened to be the date of Ballmer's promotion to CEO, and that was the subject of the story, but nevertheless the time period was unusually poor for technology returns.

Also, the newspaper made the curious decision not to show the five biggest technology stocks in 2000, but instead five of the biggest stocks. Yes, there's a difference.  Intel (INTC), left off the chart, was the third-largest technology company at the time, and  Oracle (ORCL) the fifth. Those two companies weren't great investments either, but at least they roughly broke even, as opposed to the two stocks that replaced them on the chart, the disasters that were  Yahoo and AOL .

Here are the buy-and-hold results for the past four trailing five-year periods for a basket of the U.S. stock market's five largest technology stocks. Each stock's annualized return is shown, along with that of the Wilshire 5000. In addition, the growth of $10,000 is calculated for both the stock basket and for the index. (The stock basket calculation assumes an equal $2,000 initial investment into each of the five stocks, without subsequent rebalancing.)

The lessons are not those taught by The Journal's graphic. For those four periods, there were no plunges into technological obsolescence, save for Lucent after 1998. The rapid ascent (and in AOL's case, descent) of a handful of well-known Internet companies can give the impression that technology leadership is gained and lost within a few years, but in fact the lists were quite stable. Microsoft and IBM were perennially near the top, and  Cisco Systems (CSCO) and Intel each made dual appearances.

The stock results were pretty good. The second time period contained the technology-stock crash, but even in that instance the tech-stock basket was barely in the red and actually nudged past the Wilshire 5000. Of the remaining three periods, the most recent two featured pleasant if unremarkable gains, and the first was terrific even by the high-flying standards of the mid-1990s. It's true that the baskets didn't look quite as attractive on a risk-adjusted basis, given their relatively high volatility, but they were hardly disasters.

Another item of note is the illustration of former Fidelity Magellan manager Peter Lynch's principle that for long-term stock owners, runaway winners ("ten baggers" in Lynch's lingo) are more important than the occasional dud. In the first time period, the $2,000 placed into Microsoft ballooned to $9,850 in five years, thereby nearly recouping the value of the entire original $10,000 investment. With such a head start, that basket was sure to do well. Conversely, Lucent's crash in the next time period did not sink the portfolio. Yes, the portfolio was out nearly the $2,000 it put into Lucent, but no more than that. The remaining $8,000 was still at work.

Here are the current tech leaders. As with the predecessor baskets, they probably won't be a great purchase on a risk-adjusted basis, and I wouldn't rush to buy those stocks. However, I wouldn't shudder if I owned them either--which is what I thought would be the case when I started this column.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.