Can value investors be successful technology investors?
Those of us who experienced the internet bubble of 1998‐2000 recognized the great potential for the Internet and the World Wide Web, but back then, venture capital flowed like a broken water main, and companies were being formed without a notion of where revenues or cash flows were going to come from. Value investors for the most part, at that time, focused on sectors other than information technology. Some people mistakenly believe that value investors automatically avoid technology investments.
This is simply not true. As Buffett has said, value and growth are joined at the hip. As value investors, we love to buy growth companies, but subject to an important proviso…that we are not overpaying for that growth. Back in the Internet bubble, value investors did not view the internet as a fad. There was never a doubt as far as the Internet having a huge fundamental impact on systems and processes. The overvaluation that we saw was associated with a prevailing overestimate of the speed of change and adoption…that gap between the onset of the disruptive innovation and the time when it becomes embedded and integrated among users.
Let’s get down to some basics. Most professional investors agree that a few basic factors cause stock movement. Earnings growth ranks highly as does cash flow growth. Profitability certainly is an important fundamental factor as well. Equally important are investors’ emotions, perceptions, and beliefs. Investor sentiment defines how investors see the prospects for a company, an industry, or a country’s overall stock market. Ultimately sentiment shapes investor expectations. Fundamental investors measure sentiment and expectations by assessing valuation. These basic value drivers are the same whether you are considering a food stock or a software company.
Though many of us who label ourselves value investors sometimes tend to look down at most other methods of investing, ridiculing them as lacking rationality or being too emotion‐driven, lockstep adherence to a single dogma or doctrine can lead to peculiar self‐justified beliefs that get reinforced by restricted focus on the behaviors or portfolios of others “drinking the same Kool‐aid.” Today’s markets don’t allow for this narrowminded arrogance and require flexibility and this is particularly true as we think about technology stocks. In short, many value investors simply become too imitative rather than exercise their own judgment. Hence, there is no single methodology or approach, no single screening technique, or no single metric that provides superior results continuously or reliably. Even Buffett recognized this when, in talking about how to achieve superior returns he said, “There are many ways to get to heaven”.
One of my favorite aphorisms is, “When everybody is thinking the same, nobody is really thinking!” Sometimes I think value investors fall into this kind of a thinking trap, universally accepting a single‐minded approach to a stock, an industry, or a market without fully thinking it through. Be very wary of this thinking. There are many rational choices available which may or may not, agree with your classical view or historical approach.
Great investors have applied a mosaic of thought processes to come up with their conclusions. Charlie Munger, Buffett’s partner is an intellectual jewel who relies on a vast and diverse knowledge base to support his investment thinking. Mohnish Pabrai incorporates such thinking in his portfolios and has written extensively about this in Mosaic: Perspectives on Investing and in Dhando Investor. The use of a diverse thinking process is particularly important as we think about the franchise businesses that are in the technology and media space.
Diverse, flexible approaches are needed for successful investing in whatever industry. Ultimately, what we should be thinking about is how a company wins in its particular competitive landscape. Companies win either by delivering a comparable product at a lower cost than its peers, or by delivering more benefit for a given cost, or both. Does the business have a unique hold on its customers; an advantage that can be sustainable?
A unique hold or a product differentiation often implies pricing power for these companies. The best of these companies uses its pricing power very judiciously in order to maximize long term value creation rather than anger its customer base and invite competition with too aggressive a pricing strategy.
Historically, Buffett found these competitive strengths in media companies, particularly the newspaper and broadcast companies as well as brands that delight and create an emotional pull. Media has moved from paper to the Internet, broadcasting by antenna and through the airwaves has become more customer‐specific and specialized whether through cable or through wireless reception, and the devices to receive this media and entertainment product have rapid‐fire replacement cycles rather than being viewed as furniture. Like most great brands, new media companies are fanatic about the quality of product and service, about differentiation, authenticity, and reputation.
Value investing based thinking is definitely applicable to technology. It comes down to assumptions about the sustainability of the growth rates and the likely longevity of the technological innovation. It comes down to being price conscious rather than outlook conscious and having a focus on “what is” in terms of understanding the business rather than trying to predict “what might be” or what might happen in the future.
Significant breakthroughs and innovations are exciting growth drivers for businesses. There are different levels of innovation, not all of which are disruptive, but all of which can change growth rates. With “core innovation,” a business can “change the known” by improving current offerings. This works well for established brands. With “adjacent innovation,” these firms “change the boundaries” to transform your capabilities or develop new ones. With “transformational innovation,” these very unique companies “change the game.” Transformational innovations shake up everything, bringing dramatic change to the marketplace and to a firm’s growth and profits.
Think about how much innovation we have witnessed in the last decade, the delivery of news, the development of specialty cable channels, the dependence on the Internet for communication and entertainment. The growth in human potential can be measured by numerous innovations over time, some “core” such as improved microprocessor speeds over time, some “adjacent” such as the Wall Street Journal going on‐line, and some completely “transformational” such as smart phones. In order to preserve purchasing power, investors need to keep pace with the continual growth in human potential by investing in our capacity to continue improving. Not surprisingly, much as Buffett described value and growth as being joined at the hip, innovation and investment are as well. In the recent book, Ten Types of Innovation, the authors state that innovation requires “creativity, discipline, pragmatism, ambition, analysis and synthesis.” The requirements for successful investing are exactly the same!
So technology should not be foreign turf for the value investor. The quest is the same: looking for great businesses that can sustain that greatness, yet remain underappreciated in their valuation.
Value Architects Asset Management