Thursday, May 19, 2011

Technology Stocks

So why aren't some of the tech stocks with low P/Es that have been mentioned recently on the Stocks to Watch list?

The reason is simple: everything on that Stocks to Watch list is intended to be stocks I like -- for my own portfolio -- as very long-term investments if they can be bought cheap enough. Well, there's just no technology stock that I'm comfortable with as a long-term investment.

Most tech businesses operate in an environment that's exciting, dynamic, and highly competitive.

That's precisely what too often makes their common stock unattractive as a long-term investment.*

No matter how good business looks today, it's just not that easy to predict their economic prospects many years from now.

With the best businesses that's not the case.

"At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes." - Warren Buffett in the 2009 Berkshire Hathaway (BRKa) Shareholder Letter

Here are a couple other posts related to this:

For me, it's just too difficult to judge what the economic moat of most tech stocks will look like in the long run. Occasionally, certain tech stocks have sold at a big enough discount to my own (conservative) estimate of intrinsic value that I was willing to own some shares. In other words, their price was cheap enough relative to likely future per share cash generation (and, in some cases, there's been a meaningful chunk of net cash on the balance sheet for an added cushion) that it provided a substantial margin of safety. 

So nothing great had to happen to get a satisfactory investment result.

Even then I've only been willing to slowly accumulate very limited amounts. 

They will remain, at most, very small positions and are generally not long-term investments.

That doesn't mean there aren't some spectacular investment opportunities in technology. There surely have been -- and will continue to be -- some rather exceptional winners among technology businesses. 

A winner, in this case, being those businesses that actually build and maintain a durable competitive advantage along with attractive economics. In other words, it's NOT those businesses that capture the speculative imagination and, as a result, have a common stock that temporarily -- in fact, maybe more than temporarily -- reflects the excitement. 

A big new opportunity usually means lots of well-capitalized and capable players; it usually means one, maybe two, get the big economic "prize" while many others fail. Never mind that today's winner (s) often lose what appears to be, at least for a time, an insurmountable advantage. Consistently judging beforehand who will succeed long-term, while also mostly avoiding the current or eventual losers, is rather tough to do reliably well.

At least it is for me.

Sometimes, the businesses with the most exciting prospects actually deliver on the promise. Those same businesses also often tend to sell for premium prices. Well, mostly due to a high price paid upfront, the investment result ends up being no where near as impressive as the business outcome. A similar or better result could have been accomplished with reduced risk and a narrower range of outcomes.

As always, price matters a great deal because it's an effective way to regulate the balance of risk and reward. Investment is mostly about the returns that can be achieved considering the specific risks and against alternatives (opportunity costs). It's not about whether per share intrinsic business value will someday end up justifying the current market price. That kind of approach to investing is a great way to end up correctly judging future prospects without commensurate compensation, or being wrong in such a way that permanent capital loss is the result.

So it's not just about being correct about the future prospects of a business. It's about being compensated well for being correct. That mostly comes down to judging value well, avoiding what's not understandable, and paying a price -- considering the specific risks -- that represents an appropriate margin of safety. The reality is that much of what happens in the future is beyond the control of an investor. Well, the price that gets paid is definitely one thing that an investor does have direct control over. Paying a premium price -- with the idea the asset will grow into its valuation -- is a great way to achieve subpar investment results (or worse) and take on unnecessary risks.**

I am not suggesting it never makes sense to pay what on the surface appears to be an expensive price. I am suggesting, instead, for those investments with seemingly the most potential upside, it becomes even more important that confirmation bias is held in check. Overconfidence in the "story" can lead to excessive focus on what might go right at the expense of what might go wrong. The investment process should allow for careful consideration of both. It's essential to recognize what's simply not knowable. Big mistakes can get made when the range of outcomes is very wide. Much of the investment process should be focused on the elimination of mistakes.

I am also not suggesting no one can effectively invest in the shares of technology businesses.***

Far from it. 

Some are, no doubt, actually capable of reliably picking the big winners in technology, have discipline when it comes to price, while also keeping the large and costly misjudgments to a minimum. It's just that some will overestimate their own ability to do this effectively. The result? More risk for less reward.

A sound investment approach doesn't necessarily depend upon brilliant foresight or insight; it does depend upon staying within realistically assessed limits.


* I'm speaking only in the context of investment results. Naturally, many innovative companies produce great benefits for civilization. It's just important to consider that societal benefits need not necessarily translate into attractive investment results. A correlation between the two can exist but, too often, it does not. Sometimes, the winner is only easy to identify after the fact. Other times, the clear winner is priced accordingly. Many fail in the process. So separating the winners from the losers beforehand, without making big mistakes, becomes easy only in theory. No doubt some reliably judge this sort of thing very well. Others mistakenly think they can. In the final nine or so paragraphs of this 1999 Fortune article, Warren Buffett offers some useful thoughts on this subject.
** Must be rather particularly annoying when what looked like promising future prospects mostly becomes reality yet, because of the price paid, the compensation turns out to be insufficient considering risks and alternatives. In this case, I'm referring to an investment result not a speculative result. Those who pay a speculative price then try to sell at an even higher speculative price are playing an entirely different game. Nothing wrong with it, of course, but it mostly has little in common with investment. Speculation is mostly about profiting from market price action; investment is mostly about what an asset can produce -- in terms of excess cash -- over time.
*** Charlie Munger once talked about technology investing and the important of knowing your "circle of competence":

"...Warren and I don't feel like we have any great advantage in the high-tech sector. In fact, we feel like we're at a big disadvantage in trying to understand the nature of technical developments in software, computer chips or what have you. So we tend to avoid that stuff, based on our personal inadequacies.

Again, that is a very, very powerful idea. Every person is going to have a circle of competence. And it's going to be very hard to advance that circle. If I had to make my living as a musician.... I can't even think of a level low enough to describe where I would be sorted out to if music were the measuring standard of the civilization.

So you have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don't, you're going to lose. And that's as close to certain as any prediction that you can make. You have to figure out where you've got an edge. And you've got to play within your own circle of competence."

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