Looking at the strong rally in technology stocks since the March 2003 low for the European equity ma...
Looking at the strong rally in technology stocks since the March 2003 low for the European equity market, one could be forgiven for thinking the good old days have returned.
While the fivefold outperformance of Getronics, the essentially bankrupt Dutch IT services company, should perhaps be considered an outlier, other small to mid-cap technology companies with better financials such as Pink Roccade, another Dutch IT services company, and SEZ Holdings, the Swiss maker of semi- conductor equipment, have both outperformed the FTSE Europe index by more than 100% since then.
Such stocks have boosted the IT computer services sub-sector, which has outperformed the European index by about 20% compared with the overall IT sector's more moderate 8% or so outperformance. But this is not the complete story. Whereas the FTSE Europe index reached a three-year low in mid March, the trough for the European technology sector actually occurred last October at the same time as the US Nasdaq index.
The European IT sector has gained 56.7% since 9 October 2002, nearly 20% higher than the gain since mid March.
And while the higher euro has played a part, even in local currency terms, European technology has beaten the Nasdaq by nearly 7% since March.
Even though recent gains appear stellar, in the overall scheme of things, the sector is still valued at just a quarter of the peak level attained at the height of the technology, media and telecoms bubble in early 2000. Furthermore, stock valuations are not particularly stretched. Back then, stocks traded on heady valuations such as enterprise value to operating earnings before depreciation (EV/Ebitda) multiples in the mid teens while price earnings (P/E) ratios of 30 times were considered cheap!
Examples among blue-chip names include ASML, the semiconductor equipment manufacturer, which traded on an EV/Ebitda multiple of 15.3 times in late 2000. The valuation discounted an extremely unrealistic 30% five-year earnings growth rate given that for the next three years, earnings have been negative.
Similarly for STM Microelectronics, in retrospect, the stock at e60 in 2000 was priced on a P/E ratio of more than 80 times taking the average of the last five years' earnings. At present, with the stock having rallied 55.7% since last October, it now trades on a P/E of 33 times estimated current year earnings and 22 times for next year.
The key driver to the strong run up in stocks has been decreased risk aversion on the back of reflationary policies and the ending of hostilities in Iraq. The resultant rally in bond yields to half century lows has lowered the discount rate and subsequently boosted discounted cash- flow valuations. Investor fear of missing out has also upped inflows into higher beta areas.
While the easy riskless money has been made, we need to see upgrades in earnings to sustain the rally. Although the outlook for revenue growth remains suspect, continued cost-cutting is compensating to some extent.
Move to earnings driven phase.
High operational gearing positive.
Medium-term valuations good.
Three funds to watch