It is not a pretty sight. The 18-wheeler is parked by the side of the road, steam rising from the radiator as the sun sinks on the horizon. Three sets of tires are flat, the engine may need to be rebuilt and the trucker's frustration is plainly displayed as he pounds on the hood with his fists. This was once a shiny, new tractor trailer, but with all these problems it's now a piece of junk. As one would expect, traffic is backed up for miles and miles as commuters slow to a crawl to view the problem; the delays are now measured in hours, and all the local roads feel the impact. Even though the passing drivers have seen breakdowns before, they are unable to avert their eyes from this Tech Wreck.

And you thought rush hour on Chicago's Kennedy Expressway was bad!

It seems few investors can avert their eyes from the carnage in the technology sector. The NASDAQ index peaked in March of 2000 (137% and 3000 points above current levels), yet investors remain fixated on past valuations. Last quarter's Cisco Systems earnings-review webcast attracted a reported 34,000 investors! On a broader scale, trading volume in all technology stocks remains at absurd levels: while tech stocks account for just 18% of the S&P 500's market capitalization and about 12% of the index's earnings, the sector now accounts for about 50% of the S&P 500's trading volume. Given the extreme decline in the prices of technology stocks since last year, one would think that investors would have found alternative diversions and investments by now. Yet the obsession with last era's overvalued stocks continues, and hope for recovery is as strong as ever. This mind set, we would argue, continues to offer us and our clients meaningful market opportunities. The overall environment remains challenging, for sure. But as long as most investors continue to focus on past glories, there will be great opportunities to outperform.

As we all know by now, the technology sector faces enormous challenges. The current environment is weaker than one could have ever imagined: quarterly revenues for leading companies like Nortel, JDS Uniphase and Yahoo are off 40-50%, and earnings have evaporated. We've seen past declines of this magnitude in commodities like oil, wheat and even semiconductors (orders in the past six months down 74%!), but the current weakness destroys the arguments that growth in the tech sector would be unlimited and that many of these companies have "franchises" which can counter normal economic cycles. For example, a few years ago the promise of nationwide fiber-optic networks attracted billions in capital to those who would dig and lay such lines, but only 2.6% of the nation's 39 million miles of networks is actually used (and today's capacity glut yields only bankruptcies). At best, many technology businesses have cyclical growth patterns not unlike the rest of the economy; at worst, franchise value is minimal because of the continuous challenge these companies face to reinvent their businesses and their products.

Obviously, the Internet embodied the greatest of tech hopes. It is remarkable to review the goofy rationalizations that experienced Wall Street analysts supplied to justify the sector's overvaluation and unlimited growth opportunities:

Something real is going on here...That more people are choosing to [work for and invest in Internet-related companies] results not only in potential monetary gain but the discovery of the meaning of life. (Steve Milunovich, Analyst, Merrill Lynch 2/14/00)

In fact, the Internet -- at least so far -- has proven to be more of a problem than an opportunity. As Michael Porter lays out in a recent issue of the Harvard Business Review, the Internet fosters intense price competition that reduces, rather than enhances, industry profitability. In effect, the Internet reduces any one firm's competitive advantage, thereby enhancing the bargaining power of buyers and squeezing profit margins. This is the great paradox that many technology companies face.

While intense price competition has plagued most areas of the technology sector, matters are made even worse by the cost structures of many of these firms. Because these companies' costs are more fixed than variable (i.e. R&D, expensive manufacturing equipment, marketing, intangibles), revenue declines lead to evaporating profits. Much of this cost structure problem was the result of a massive capital spending binge which created today's -- and tomorrow's -- overcapacity. When growth is rapid, these companies surely benefit from this operating leverage, but today the reverse is true. The fiber-optic companies fit this model, as do the PC manufacturers, most software companies and even online brokerage companies. The obvious conclusion we reach is that high and sustainable profitability will be an elusive goal for many tech companies.

As mentioned in a previous letter, we have devoted more of our research effort in recent months to this very sector. With so many of the tech stocks down so far in price, we were hopeful that we would find dozens of attractively priced stocks for our portfolios. While a few names have met our strict fundamental and valuation criteria, the vast majority have not. As the preceding discussion points out, there are some troubling issues many tech companies face, including overcapacity, intense price competition, structural cost problems as well as the difficulty of trying to define "trend" in an industry that has exhibited enormous volatility. But perhaps the greatest challenge facing tech stocks right now is valuation -- expectations and stock prices for many of the companies appear to be too high for the fundamental environment we've just described. The top tech stocks -- to the extent they even generate profits -- still carry average P/E multiples near or above 50x trailing earnings, representing the misplaced hope and stubbornness of a legion of investors and traders. And these P/E ratios will surely rise further as the earnings decline continues. So more than a year after the bubble burst, investors seem to expect profit and stock price rebounds that to us look less likely. It's time for many investors to move on from this Hollywood-like fixation: investing is not supposed to be sexy -- it requires common sense and a willingness to consider new opportunities as they arise.

Clearly, our portfolios have profited from the current environment (so we're not too bothered by the market's continuing obsession). While our holdings have faced the same economic slowdown as the technology sector, the earnings impact has been considerably less. In addition, the low absolute and relative valuation of our stocks has provided a supportive price floor as well as the opportunity to profit from positive surprises. With the rest of the market focused elsewhere, we have particularly benefitted from owning a diverse set of more mature businesses that have continued to produce solid earnings growth or have successfully restructured their operations. Even though many of these stocks have bucked the market trend and risen over the past year, valuations remain reasonable and we continue to find new opportunities each week. And to answer the obvious question, we will probably own more tech stocks in our portfolios when these stocks are featured less often on CNBC and market prices are a lot lower.

Three months ago we argued that the current economic downturn appears to be cyclical (rather than structural) in nature. There is a great deal of overcapacity in certain sectors of the economy, and the combination of lower interest rates from the Fed and soon-to-arrive tax rebates should ultimately stimulate economic activity. Cycles are a recurrent pattern of both economic and market history, and we have not yet found a compelling reason to argue against history; economic recovery during the next year is still the most likely outcome. Our biggest concerns, frankly, are too-high expectations and valuations in the tech sector. We suspect this means further disappointments are likely in this area of the market, and our disciplined value approach should continue to insulate our portfolios from this risk. This will be important as we seek to protect our recent portfolio gains as well as identify tomorrow's most attractive equity opportunities. Unlike many investors today, we prefer to look for new opportunities rather than dwell on the past.