From the October 2006 issue of Research Magazine • Subscribe!

October 1, 2006

When Good Sectors Go Bad

At one time, technology was the envy of the market world. Today, years after the sector turned from investor darling to scapegoat, the bleeding continues: Most ETFs tracking technology indices are posting negative year-to-date performance returns.

Weak financial results are just part of the problem. Both the SEC and the Department of Justice are investigating at least 55 technology companies for illegally backdating stock options. While the gimmickry is not limited to technology companies, a disproportionate number of them -- including Altera, Broadcom, Comverse Technology, CNET Networks and Vitesse -- have either been investigated or suspected of backdating. These aren't penny stocks or companies with novice managers. Many are established billion-dollar enterprises and, crucially for ETF investment strategies, just happen to be key components within technology indices.

What makes this practice so alarming is the negative impact it may have on these companies' real earnings. In most cases, reported profits are overstated because they don't include the millions of unaccounted option shares issued. Furthermore, the unknown number of companies that will have to restate earnings because of illegally backdated stock options casts a long shadow over the entire sector. Even though the Select Sector Technology SPDR (XLK) was recently trading at its cheapest forward P/E in history (15.2, according to AltaVista Independent Research), consensus earnings estimates on the index -- which generally aims to mirror the performance of the overall sector -- may still be too rosy.

In short, compared to other sector opportunities, technology remains overvalued. The problem with the technology industry has never been innovation. A lot of the problems emerge when these companies apply that "innovative" approach to the way they count the numbers. Just how much of the current tempest with backdated stock options was caused by the high-tech industry's already too-liberal treatment of stock options? If you talk to the wrong people, they'll tell you there's no connection. For the rest of us, the coincidences are too coincidental.

To regain its credibility, the technology sector needs to abandon its dinosaur accounting practices. An excellent start would be to quit opposing accounting standards that recognize the negative impact of stock option handouts on the income statement. Any other stance weakens the believability of financial results. Isn't it a paradox that the one sector renowned for its progressive approach to business should be so prehistoric in how it calculates the bottom line?

There's no doubt that expensing stock options hurts a company's earnings because it adds additional labor cost, but the alternative is even worse. A few companies in the sector understand this. For example, IBM recently adopted the Financial Accounting Standards Board's rule known as "SFAS 123 (R)," which makes expensing stock options a financially transparent activity.

Because tech ETFs are indices of technology stocks, they need to be evaluated as such. Regardless of how high they fly or how far they drop, sectors -- like the individual stocks that comprise them -- are never a good deal when corporate insiders aren't working for the good of their shareholders.

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