Technology – A Divergent Sector

Jim Pearce is Investing Daily’s Wealth Society director and a former investment advisor with 30 years of portfolio management experience. Leo Boeckl, a long-time tech industry strategist and insider, is the inventor of a proprietary valuation model for tech stocks that has worked with uncanny accuracy.  Please click here to hear them discuss the approach they take to evaluating tech stocks.

Diversification can sometimes hurt you

Sector investing has become increasingly popular in recent years, as the proliferation of ETFs (exchange traded funds) has made it very easy for investors to acquire a diversified position in a specific industry or geographic area. In most cases it makes a lot of sense to use an index fund as a proxy for this purpose since that greatly reduces the risk of owning a small number of stocks that may not mimic the overall performance of their sector.

However, some industries are composed of such widely divergent performance characteristics that owning an index fund can greatly reduce the likelihood of achieving above average returns. In those rare cases it is better to own a portfolio of market leaders within that industry rather than an index fund that includes the laggards along with the leaders.

The technology industry is one such sector that possesses an unusually wide divergence between its leaders and laggards. For every top performer like Apple, there is a failure like BlackBerry to offset the opportunity for exceptional gains. In order to separate the Apples from the BlackBerrys, one must understand the critical success factors within the technology industry and then identify those companies that possess them.

Thirty years of convergence

To explain why some tech stocks have exploded in value while others have fallen by the wayside it is critically important to understand the concept of “convergence” as it applies to this industry. The reason why convergence has been so disruptive during the recent past is that when a physical object – such as a book, record or picture – is reduced to a digital code of ones and zeros it can be reused almost anywhere quickly and cheaply. An actual book requires the costs associated with a printing press to be created and another set of costs to be delivered, while an “e-book” requires little more than the press of a button to be reproduced, and another press of a button to immediately send it anywhere in the world.

Convergence has also been massively accelerated by the relentless march in chip miniaturization. The engineering implications of “Moore’s law”, which postulates that the number of transistors per square inch will double approximately every 18 months, is that an increasing amount of computing capacity can be accommodated by increasingly smaller devices.

In general terms, convergence describes the process of many different starting points all moving towards the same end point. With respect to tech stocks, it specifically refers to the consolidation of a wide variety of early-stage products into a small number of end-point products that will become the core technologies in the decades to come.

Survival of the fittest

For example, where are the Palm Pilots, Motorola Flip Phones and Creative Labs Nomad MP3 players from the latter 1990s? Those were the cutting edge tech products just a few years ago. The answer is that those technologies have been consumed into other products or rendered totally obsolete. Apple’s release of the iPod in 2001 has already been dwarfed by its own iPhone.

Most people now carry only a Smartphone for all music, email, calendar and web surfing needs. Even my GPS unit sits dormant in the glove compartment of my car as Smartphone Apps have replaced that need as well. A few years ago these were all separate devices. But now, as a result of convergence, all of those activities are being done digitally via electronic bits that are easily integrated into ever smaller, yet increasingly fast and more powerful Smartphones.

The first question we always have to answer is where any given company’s products currently stand in the persistent drive towards convergence in technologies. Though a company may have the capacity to build 100,000 units, that doesn’t necessarily mean that the market will be interested in those products once they reach store shelves.

What Apple knew that Blackberry did not

That is what sets the tech industry uniquely apart from all other sectors in terms of evaluation. There are still trains, planes and automobiles… but no Palm Pilots! Further, the shiny new tech gadgets trigger emotional responses when their manufacturers post huge sales. In 2003 Motorola released the sleekest looking new cell phone called the Razr (pronounced razor). By 2006 it had sold a whopping 130,000,000 Razrs. Could its future have looked any brighter to even the casual observer?

Motorola failed to relentlessly focus on digital cellular tech convergence, or where convergence was taking the cellular markets. As a result, it was trumped the very next year by Apple’s iconic iPhone release in 2007. Apple has never looked back while Motorola has since broken up its business units and sold off many of its patents and large chunks of the company.

Why did a company like Apple – which did not invent the cell phone, the MP3 player, the Internet or email – come to dominate an industry seemingly overnight, displacing highly entrenched successful companies like Motorola, Blackberry and Nokia? It was due to how it managed technological innovation and integrated new technologies into its products. That’s something we call “innogration”, and is the reason why all tech companies ultimately thrive like Apple, or fail like Blackberry.

Next Issue: Understanding Innogration

SPECIAL ALERT: In a future issue we will explain exactly why we think Apple (NASDAQ: AAPL) is a tech stock worth owning at current levels, but for now we’ll leave it at this: while most other tech investors are focused on Twitter (NYSE: TWTR) as a result of its recent IPO, we think Apple offers tremendous value due to its attractive dividend yield (over 2%), huge cash reserves (more than $40 billion in cash and short term investments), and the huge success of the recent launch of its iPhone 5S. And it is only trading at 13 times earnings, far less than Facebook (118 times earnings), Netflix (282 times earnings) and other companies dependent on advertising as their primary source of revenue. Our opinion? Apple is a strong ‘buy’ up to $545.

View Part 2: Understanding “Innogration”

View Part 3: Measuring Innogration to Evaluate Stocks

View Part 4: Converting BiQ Scores to Buy and Sell Recommendations