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Author: BruceBrown Big gold star, 5000 posts Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 18386  
Subject: Why bet on suckers?... Date: 6/5/2000 5:03 AM
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natererdp wrote:

A company at 10 P/E has less downside range than one trading at 100 P/E. A bad pick of a "value" company results in underperformance. A bad pick of a speculative company at 100 P/E can result in loss of principal! For more insight into the use of P/E as a margin of safety, read John Neff.

A company with a P/E of 10 might also signal very low profit margins. It's just one metric. For that matter, net margins are also just one metric. However, quite often a parallel can be drawn between low P/E and low net margins. There is a reason General Motors has a TTM P/E of 7.94. Net margins at GM declined to .037 in the latest quarter. That might be a general statement, but statements of high P/E metrics being a sucker bet might also be taken as a generalization.

Look back to the Nifty Fifty. The worst investments during that time, when large-cap technology stocks were considered "sure things", were large-cap tech stocks like Xerox, Polaroid, and IBM. They all underperformed the market for the next 25 years. What about the 80's, when some of the predominant names included IBM and Wang? Many of them no longer exist or are no longer dominant in their fields.

Now you've stepped into the area of technology grave digging. Would you be able to tell us exactly why IBM, Wang, Polaroid and Xerox underperformed the market for the next 25 years? I would. I guess we could start with discontinuous innovation. We could mix with that, at least in the case of IBM and Xerox, two of the most ugly management blunders of some key issues at key times concerning proprietary enabling technology. In short - they blew it and blew it big. In terms of history in high technology, they both made blunders that were not possible to recover from in terms of managing through the tornado. This is more the key to their underperforming the market for 25 years than anything to do with market multiples along the way.

The "bad news" is that discontinuous innovation in technology is not going to stop. This is also "good news" because it means that investment opportunities will be available for us because of DI for the next 20 to 50 (or more) investing years of our lives. I view that as an exciting prospect. One that will create another Microsoft, another Cisco, another Intel, another Siebel, another Oracle, another Qualcomm and all the value chain players that surround and support the gorilla. It also means that the simple strategy of buying the current gorillas and holding for 20 or 30 years is not a valid strategy due to what discontinuous innovation can do to maturing technology adoption life cycles and the dominant players within those cycles. Wang was an example of that and Polaroid - well that's another story that is worth study as well in terms of film and camera technology evolution.

Plenty of pundits on the Breaker and Maker boards snuff the idea of Breakers, Makers and Gorillas. That's fine. It's not going to stop them from happening though. Other good news as we contemplate the graveyard of past gorillas and their faults centers around management of a high technology company through the chasm, the tornado, main street and beyond into the service cycle. To say that lessons have not been learned over the past 40 years and that those lessons are well known, taught and practiced would be to ignore reality. If you took today's skilled leaders of high tech management and allowed them to go back 25 years with the knowledge they now have at their disposal to guide the ship of IBM and Xerox (maybe even Polaroid), we might be discussing a very different outcome today. What would a group with the knowledge of John Chambers, Steve Jobs, Craig Barrett, Greg Reyes, Irwin Jacobs, Bill Gates, Tom Siebel, Larry Ellison, Steve Ballmer, Sanjiv Sidhu, Michael Ruettgers and Michael Dell have to contribute in terms of chasm, tornado and main street management throught the technology adoption life cycle? What I'm trying to say is that although discontinuous innovation will continue to happen (and needs to happen), today's high technology companies are much more aware and the strategic warfare is much more advanced and commanded now than it was 25 years ago. Hence, we have dominant companies today that are not only more powerful, but also more paranoid. The combination of the two makes for a compelling argument of continued performance and tornado S curves. Cisco does it the best, yet Intel and Microsoft are on the ball.

So, to some extent, I agree with Bill -- large-cap tech stocks are suckers' bets. They are everyone's favorites, and for that reason they have reached valuations that make them unlikely to beat the market.

Once again, there are possiblities for small and mid-caps in the technology industry that will become dominant in the future. Yet, with the skilled knowledge of how the high technology industry works and this knowledge having been passed all the way through the investing spectrum, finding tomorrow's Cisco or Microsoft doesn't allow for uncovering any valuations that might seem anything but way overvalued to most investors eyes. It just doesn't happen that way. The premium in price you have to pay for the smaller companies that have a discontinuous innovation and are poised to dominate their niche sector going forward might carry even more risk and more of a 'sucker bet' than the large-cap dominant companies that are now in position to simply print cash on a daily basis. Why? What if their innovation doesn't become the standard? Technology investing is not an easy path and requires a lot of attention to detail to be successful over the longer term. This, in spite of the fact that the growth waves have taken everything up the beach over the last few years. However, when that water retreats back into the ocean, there will be companies left far up the beach that will march inland and dominate for years to come. The close study of technology adoption life cycles is key. The market has become quite skilled at predicting sooner who will walk up the beach to the inland. Hence, the valuations are 'goosed' earlier in the cycle than in previous history.

Today, there are some large-cap tech stocks -- Oracle, Sun, Microsoft, Yahoo -- that have great business fundamentals.

Having an enabling proprietary technology, be it hardware or software, certainly increases the odds of great business fundamentals if properly managed.

The other difference -- and this is where the investment risk of technology investing comes in -- is how sustainable is the company's growth? What competitive advantages does it have? For a long time, before the recent bull market, technology companies were considered risky investments because technology changes too fast for companies to acheive true sustainable competitive advantages (Dell was once trading with a P/E in the teens!). History bears this out with a couple of rare exceptions (Microsoft, Intel). Have things changed? Have we entered a "new era"? We simply cannot predict the future. Therefore, technology investing has to be considered risky and the current lofty valuations a result of a somewhat speculative frenzy for stocks that are perceieved to have great potential but really have very uncertain futures.

Now you have arrived at the core of reality. The rare exceptions include Intel, Microsoft, Cisco, Oracle, Qualcomm, Siebel, i2 and there are many others on the way. They all own enabling proprietary technology - be it application or hardware. Dell owns no proprietary enabling technology, but is and has been a dominant player in the value chain of the PC technology adoption life cycle since the mid 90's. We also have the enterprise networking adoption life cycle and now the bridge into the all important IP/Broadband (Next Generation Networks) technology adoption life cycle which is underway. A lot of money will be made by the dominant companies and by the investors in those companies (probably more than the PC technology adoption life cycle created along the way). Valuations will most likely remain rich for all the key players. What does this guarantee for us as investors? Endless continued debate about valuations. To dream that you can find a dominant proprietary enabling technology company with a P/E of 10 or less which has a healthy business model may or may not fit the realm of realistic dreaming for high tech investing. We could even bump that TTM P/E metric up to 15 or 20 or 25 or maybe even 30 and question the value of such dreams.

Is it all a sucker bet? I think not.

BB
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