From Bellwether to Straggler

One classic stock-trading strategy requires an investor to find two companies in the same business–say, Ford and GM–whose stocks have significantly different valuations (one useful proxy of this can be their price-to-earnings ratios). Buy the cheap stock and short the expensive stock, the thinking goes, and as the prices of the two converge you’ll be a big winner.

The problem with this strategy is that sometimes two companies, even if they’re in the same business, deserve significantly different valuations. Although every auto company is affected by broader secular trends in things like auto demand, gasoline prices, and the business cycle, some auto companies are more efficient and productive than others, and some are better at giving consumers what they want.

An obvious point, to be sure, but one that’s easy to forget in a business world as competitive as this one, where every innovation seems to be easily mimicked and where only something like Microsoft’s ownership of Windows appears to be a source of competitive advantage. It’s also one that’s easy to forget when you look at the collateral damage that Compaq wreaked, not only on PC stocks but also on the entire technology sector this morning in the wake of its announcement late Friday that its earnings in the latest quarter would be half of what analysts had been expecting.

Now, the stock market rebounded nicely from Compaq’s news, with even the Nasdaq ending up in positive territory. But when the day opened, the S&P futures were down an astounding 17 points, and the Nasdaq fell nearly 3 percent in the first few minutes. If Compaq was having trouble, every other PC maker must be having trouble, which means that all the semiconductor makers and disk-drive makers must be having trouble, and Microsoft as well, and perhaps even other tech companies that did a lot of corporate business, since Compaq said corporate demand for PCs was weak.

In other words, there were a lot of stocks to sell when the day opened. But for people who were thinking, most of those stocks were stocks to buy, and at bargain prices. (Well, OK, they were relative bargains. In this market, there are no cheap tech companies, at least none that are any good.)

There’s no question that there have been dramatic changes in the personal-computer market since a couple of years ago. The sub-$1,000 PC has altered the business for good, and that has had important ripple effects through the semiconductor and disk-drive industries. But Compaq’s woes are more company-specific than industry-driven, though Compaq will tell you the opposite. Look at Dell. More than a month ago, its stock took a sharp hit because its sales growth was slower than anticipated. But all that meant was that its sales were growing 40 percent year over year. And its profits are still growing faster than that. If Compaq’s sales were growing 40 percent a year, investors would be leaping for joy (instead of leaping from windows).

Compaq doesn’t know what it wants to be. It built its business on a traditional reseller model–it makes the PCs and then sends them to dealers, who sell them–but recently announced that it would begin selling direct, as well (like Dell and Gateway). But it can’t go fully direct because that would alienate its resellers, and it’s not ready to abandon its resellers because it hasn’t redesigned its business around the direct-selling model. Similarly, it bought Digital because it wanted to be a player in the world of mainframes and computer services. But these are capital- and labor-intensive businesses, and Digital was so large that integrating it with Compaq has been predictably difficult. Now Compaq’s making noises about an Internet strategy, acquiring the Web site, spinning off its Alta Vista search engine, and so on. But there’s no sense of a real vision there.

Compaq was one of the great turnaround stories of the 1990s. But it’s no longer the bellwether it once was. You can’t look at Compaq, see problems, and assume that they’re the result of broader economic realities. Compaq is responsible for what’s happening to it right now, and by the end of the day today, that seems to be pretty much what investors realized.