Investing in Technology Stocks

I went to see Keith Weiss, software analyst at Morgan Stanley yesterday.  He made a good presentation on the stocks that he followed, but I particularly liked one of his charts which I have posted above.

Although his chart only focuses on the stocks he follows, it illustrates very well the challenge for portfolio managers interested in the technology space.

Most of the tech area breaks down into the three sectors that Keith displays.  First there is the "value" sector which usually includes older tech companies whose best growth days are behind them but still are incredibly robust and profitable companies.  Good examples in the software space would be Oracle and Microsoft, which both trade at a discount to the S&P 500 but still are obviously major players in the technology area.

Then there's the middle sector, which Keith calls "story stocks".  These are stocks which usually trade at a premium to the market multiple since their growth rates are still strong and the potential for future gains are still ahead.  In the software arena, this would include companies like VMware and Red Hat.

Finally there are the dream stocks that Keith has called "hyper-growth". The valuations of these stocks makes no sense until you realize that the growth rates of these companies are incredible.  In Keith's universe these are names like Salesforce.com and Fireeye (I suppose Twitter would also fall into this category but Keith does not follow the company).

Bernstein Research has looked at the past performance of tech stocks, and has found that a barbell approach involving value tech and hyper-growth tech tends to outperform over time. The stocks in the middle - the story stocks - usually wind up being laggards.

In the Long Run, Everything is a Toaster

I loved the way that John Authers started his "Smart Money" column in this morning's Financial Times:

In the long run, everything is a toaster.  This is one of the more memorable lines delivered by Professor Bruce Greenwald, who teaches the class in Value Investing at Columbia Business School that was once taught by Benjamin Graham, and taken by Warren Buffett.

The comment is a classic put-down by value investors against the overhyped hopes of rival "growth" investors.  Great innovations may make money for a while, they say, but eventually they will be commodified and compete on price, like everyone else - much like a toaster.

http://www.ft.com/intl/cms/s/0/3123fcde-3b0a-11e3-87fa-00144feab7de.html?siteedition=intl#axzz2ifvb6frE

Authers goes on to discuss how Cisco - the router company that once sold at a multiple of 200 times earnings in the height of the dotcom bubble - is now trading at a discount to the S&P 500 (15x vs. 18x for the broader market index).

At the same time, Authers points out that Cisco is a much stronger company than it was a decade ago.  It pays a dividend, tells investors that it has more capital than it needs, and strengthened its core business.  In short, it has all of the attributes that a true value investor would typically desire, yet few seem to have any interest.

Cisco is only one of any number of tech companies that trade at very attractive multiples.  Apple and Microsoft are available for only 12x earnings, pay attractive dividends, and continue to put up growth rates that most of corporate America would envy.  IBM is offered at less than 10x, pays a dividend, yet has been widely panned by Wall Street for delivering third quarter results below Street expectations.

Meanwhile, over in the consumer staples space, tepid growth is rewarded with high multiples.  Coca-Cola, for example, trades at a multiple that is nearly 50% higher than large cap tech, yet it growth rates are projected to be less.

Why the anomaly?

I thought Authers captured it well in his last paragraph:

Big technology companies, with their high public profile and large market caps, are unusual candidates to be value stocks. But in this case, the value may be hidden in plain sight.  Either way, it is time to consign the dotcom bubble to the history books.  Technology has matured, and the market looks as though it may have exaggerated the extent to which it has matured. There is good reason to expect more interest from value investors in large technology stocks.

Technology Tales

For people that don't actually work at a technology company, the tech world can seem pretty cool.

Working in an area where the pace of change has been breath-taking, and the potential for fabulous wealth apparently unbounded, the tech world seems to offer the best of all possible career paths.

The reality, of course, is considerably different.  High tech companies tend to be filled with brilliant employees working incredibly long hours under very stressful deadlines. Only a handful of companies ever achieve the kind of financial success that a Facebook or LinkedIn achieve; 75% of all tech companies fail, according to some estimates.

Three articles that I have read over the past week gave me a good glimpse into what it's like to work in technology.

Oracle is one of the giants in the technology business. Started 36 years ago, it has made a number of its founders incredibly wealthy, most notably multi-billionaire Larry Ellison.

Ellison hired Mark Hurd a couple of years ago.  Hurd had been head of Hewlett-Packard but became embroiled in a personal controversy that lead him to leave HP.  Ellison quickly hired Hurd, and now Hurd is one of the chief salespeople for the company.

When you reach the size of Oracle, achieving sales growth can be a daunting task, as a recent article in the New York Times reported.  Here's what a typical week for Hurd looks like:

A few hours watching Mr. Hurd (something Oracle allowed me to do on the condition that some negotiations and customers not be identified) is a healthy reminder of a basic truth about the technology industry. The world sees and thinks about its gee-whiz products. It loses sight of the reality that sales make all the rest possible.

Oracle became big in its 36 years thanks to one of the strongest sales cultures in technology. You can find so many of its former sales executives throughout the industry that sometimes is seems like the Valley’s finishing school for deals. And whatever the business, sales still is all about relationships....
 
It’s a heavy pace, but not that abnormal in Mr. Hurd’s life, says Julie Tung, Oracle’s vice president for global customer programs. “We aim to be out five weeks a quarter, generally three days of the week with customers,” she says. ”The target goal is 50 customers a day, with no more than 18 people if it is a round table, so they all feel like they’ve had some one-on-one time with Mark.” 

Ms. Tung lives in New Jersey and Mr. Hurd is based in California, but it hardly matters when you are getting up close and personal with 3,575 customers a year.

http://bits.blogs.nytimes.com/2013/10/02/mark-hurd-oracles-master-salesman-wants-your-business/

Amazon.com is another hugely successful technology company. Started by Jeff Bezos in the early days of the internet, Amazon records $75 billion a year in revenue, and continues to grow at an incredible rate.

Working at Amazon, however, is very demanding and can be very stressful. A recent article in Bloomberg Businessweek carried an excerpt from a new book on Amazon.  Here's an excerpt:

Within Amazon.com (AMZN) there’s a certain type of e-mail that elicits waves of panic. It usually originates with an annoyed customer who complains to the company’s founder and chief executive officer. Jeff Bezos has a public e-mail address, jeff@amazon.com. Not only does he read many customer complaints, he forwards them to the relevant Amazon employees, with a one-character addition: a question mark.

When Amazon employees get a Bezos question mark e-mail, they react as though they’ve discovered a ticking bomb. They’ve typically got a few hours to solve whatever issue the CEO has flagged and prepare a thorough explanation for how it occurred, a response that will be reviewed by a succession of managers before the answer is presented to Bezos himself. Such escalations, as these e-mails are known, are Bezos’s way of ensuring that the customer’s voice is constantly heard inside the company.

http://www.businessweek.com/articles/2013-10-10/jeff-bezos-and-the-age-of-amazon-excerpt-from-the-everything-store-by-brad-stone

Twitter is about to do an IPO, so it is timely that Nick Bilton of the New York Times has written a book about the company.

While some of the individuals who started at the company are soon to become wealthy, it is noteworthy that the idea of Twitter was not necessarily unique.  According to Bilton, luck plays as much a role in the success stories in technology as originality and skill:

For the ones that make it, success often comes down to a lot of luck. YouTube was one of dozens of video-sharing sites in existence when it was purchased for $1.7 billion by Google. Instagram wasn’t the first app on iTunes to share photos, yet Facebook still paid $1 billion for it.Twitter wasn’t the first place to share a status online; it was certainly the luckiest. ..Seven years after it was founded, the company with a catchy name had more than 2,000 employees, more than 200 million active users and a market value estimated at $16 billion. When it makes its initial public offering, many of Twitter’s co-founders, employees and investors are going to become very, very rich...

But in Silicon Valley, luck can be a euphemism for something more sinister. Twitter wasn’t exactly conceived in a South Park playground, and it certainly wasn’t solely {President Jack} Dorsey’s idea. In fact, Dorsey forced out the man who was arguably Twitter’s most influential co-founder before the site took off, only to be quietly pushed out of the company himself later. (At which point, he secretly considered joining his biggest competitor.) But, as luck would have it, Dorsey was able to weave a story about Twitter that was so convincing that he could put himself back in power just as it was ready to become a mature company. And, perhaps luckiest of all, until now only a handful of people knew what really turned Twitter from a vague idea into a multibillion-dollar business. 

http://www.nytimes.com/2013/10/13/magazine/all-is-fair-in-love-and-twitter.html?pagewanted=all 

Hard work, stress and luck - all ingredients, it seems to succeeding in the technology world.