In a column for this newspaper back in 2006, I argued that the equity and bond markets were finally coming together. Bond and equity analysts were starting to look at companies through the same lens and would therefore arrive at similar conclusions.
Sadly, it has not turned out that way. Not only are the interests of the two classes still frequently opposed, their psychology is too. As one senior broker puts it, bond folk walk along the pavement looking for cracks while the equity folk lie in the gutter looking at the stars.
Optimism is, of course, an essential ingredient of capitalism. No risk, no gain. Being star-struck is another matter.
Consider the case of the UK chip designer Arm, whose shares last week finally regained their level of 10 years ago. The date rings a bell; 2001 saw the tail-end of one of the biggest bursts of stargazing in living memory; the dotcom bubble.
As a modest-sized tech company, Arm was both beneficiary and victim of this bizarre episode. At the start of 1999 its price was 65p. By March 2000 – the peak of the boom – it was 986p. By October 2002 it was below where it started.
Fast forward to the start of 2009, when the shares were at 82p. At that point they started to motor again and at one point last week they hit 536p. This valued the company at £7.1bn ($11.3bn), or about 98 times trailing earnings and almost 19 times revenues. Dotcom time again?
Not quite – or not at the overall market level, anyway. In the past two years Arm has outpaced the US tech-laden Nasdaq index almost fourfold. This is an issue specific to the company, or at least a small group of companies.
Founded in 1990, Arm is an admirable specimen of the high-tech enterprise, producing innovative chip designs, which it licenses out to chip manufacturers.
But there is a slight weakness in the business model. Arm sells to the chipmakers, which then sell to makers of mobile phones, laptops and so forth. It is therefore at the lower end of a ferociously price-competitive pyramid, and raising prices is a struggle.
Its most recent full-year figures for 2009 (figures for 2010 are due next week) displayed that fact. Since 2001 – when its shares were last at this level – average annual sales growth was 10 per cent, but compound growth in net profits was just less than 2 per cent.
Indeed, net profits in 2009 were down on the year before. Yet in the course of 2009 the shares doubled. What caused that?
In a word, Apple. Arm-designed chips are in almost all mobile phones and smartphones use up to six. So the newly resurgent Apple is a prime end-customer, for both its iPhones and iPads.
That had no effect on Arm’s 2009 figures, even though as global sales of smartphones rose 30 per cent. But last year was catch-up time. Earnings per share in the 12 months to September were up 75 per cent, on sales up 20 per cent.
Pretty good – though whether good enough to justify those sky-high multiples is another matter. At this point, however, enter a second player – Microsoft.
This month Microsoft said Windows 8, due out next year, would support Arm-based technology. Goldman Sachs promptly forecast this would raise Arm’s share of the computer market from its present 7 per cent to 45 per cent by 2015, and would add $1.2bn (£750m) of revenue in the course of the next decade.
So there we have it. Never mind that Arm’s sales growth in the past 12 months has been less than half Apple’s, or that its share price is 19 times sales against Apple’s less than five times.
Never mind, either, that Arm’s earnings record is patchy and that in four of the past 10 years its net profits have been lower than the year before. This is one of those must-have stocks, like Google in its early days. The price is immaterial.
It may be correctly inferred that I am not of the stargazing fraternity. Indeed, I would argue that this kind of extreme market behaviour is not merely perverse, but can be harmful.
When Arm’s shares return to earth, investors will feel cheated and resentful. Yet the fault is entirely theirs. It is good news that Arm is going through a winning streak. But if the market has its way, the company may end up paying.