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tech confessions from a value investor

1 Nov

It was about a decade ago now that a friend and I started an investment partnership.  The venture was my first foray into managing money for others (friends, family), and it accomplished its intended goal.  First, it made us concentrate on discussing investments on a regular basis.  It established a disciplined feedback mechanism.  It’s like having a running partner – you don’t want to let the other person down.  We discussed strategy, generated ideas, developed reports and wrote letters indicating our thoughts on a regular basis.  The letters are fun to go back and read.  Some things were missed in those reports, however, including many errors of omission that appear glaringly large now.  This post somewhat of a post-mortem along those lines.  While we made plenty of mistakes on the stocks we actually bought, in retrospect, far worse decisions were made with respect to those we discussed but did not buy.  Case in point: Amazon.

Almost from when I began investing, I have been a devout value investor.  (Exception: about the first year.)  The books I read were almost exclusively ‘value’ based.  If I had a mentor, it would be those books and Warren Buffett.  Almost all of them, save a few, dismiss investing in technology stocks almost out of hand.  Buffett, for example, hasn’t touched Microsoft – except for 100 shares in order to receive the annual reports – even though his friend Bill Gates is one of the most brilliant folks he’s met.  (Also, Buffett has jumped into technology lately with his BYD investment, but that’s another story.)  The point is, when I started my mentally was to do the same: dismiss ‘tech’ investments almost out of hand.  “There are enough investments without technology stocks,” I’d say, plus I put them in the ‘too hard’ category.  It’s too hard to figure out what the future will look like.  So I avoided them.

The first rule of investing is ‘don’t lose money’ and the second rule is ‘don’t forget rule #1,” so looking at it from this perspective not investing in fast-changing tech makes a lot of sense.  It IS hard to figure out what the future economics of a business will be, let alone one that is heavily involved in technology.  Underestimated, however, was just how powerful some of these businesses could become.

Anyway, we went on to pass up investing in Amazon.com, at $7.  It was mostly my fault.  I would later pass on the IPO of Google.  I read about the pricing of the offering and considering it too expensive.  (In my defense, IPOs tend to be horrible times to invest.  Who would want to buy from a super-knowledgeable seller?)  Of course, the $85 IPO price looks like a bargain now.  Netflix was another.  I actually bought puts on the stock, trying to profit when the stock fell.  (It hasn’t.)  I must also note that I used Amazon a lot, performed web searches via Google, and was also a Netflix customer.  I loved each of their services.  I thought all three were great companies.  It came down to what I considered a high price in relation to value that I wasn’t willing to bet partners, client, or my own money, on them.  While I’m being masochistic, throw Apple in there, circa 2001.  I passed this over in spite of having several friends who used Macs and loved them.  Oh, then iPods came out…

Buffett has said that “growth” is a part of the “value” equation, that they are not distinct and separate.  This is something  I agree with wholeheartedly.  I’ve always used growth when valuing companies.  It’s the stinginess that, I think, made me not properly consider how growth could impact valuation if returns on capital could be maintained even at very high rates of growth.  Statistically this is very rare.  I also failed to weigh heavily enough how much the people running these companies mattered.  Bezos, Brin/Page, and Hoffman are phenomenal folks — that’s a key takeaway.

Allocating scarce capital involves many tough decisions, and for me the errors of omission keep me up as much as those of commission.  Of course, it’s easy to look back at the winners and say I missed them.  In the intervening period, there were successes in more ‘boring’ companies.  Still, reviewing one’s mistakes is FAR more useful as a learning tool than reviewing successes.  Failure, like success, can involve more luck than skill, but if you know you passed it over for ‘rational’ reasons it’s worth exploring those reasons and considering their validity no matter how much time has passed.   Too, I didn’t buy a bunch of high-flying technology stocks only to see them collapse 95% and lose it all.  So there is some advantage to investing – or not investing – according to a value discipline.

This post is already long enough to make folks who are reading it start to drift off, so I’ll stop here.  In closing, I am certainly more open to technology investments now, but I still prefer to buy the profitable toaster manufacturer trading at $5 with $10 of net cash on its balance sheet.  If I can have a 90% probability of a base hit versus 5% probability of a home run, I’ll still lean toward the base hit.

Disclosure: I own shares of Google (GOOG). 

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private market froth-iness

11 Feb

While it’s not clear there is a bubble yet, some of the private market valuations I’ve seen are bubble-icious. My evidence is more anecdotal since I’m not an “on the ground” venture capitalist. But here is something from Fred Wilson, offering a good overview from a very credible source that there is a froth in the private markets. Money is sloshing around the bathtub, and I’d argue it’s spilling over into all asset classes.

Remember W.B.: “The first rule of investing: Don’t lose money. The second rule: Don’t forget Rule #1.” Remember the downside, grasshopper.

MSFT-YHOO?

4 May

Microsoft (MSFT) to buy Yahoo (YHOO)? I must confess that can’t see an acquisition happening, but I suppose it’s possible. The market seems to believe something will happen, given Yahoo shares are up over 15% today. With Google (GOOG) owning over half the market, and growing at more than double the rate of Yahoo’s and Microsoft’s respective online advertising efforts this past quarter, I believe each needs to take action to become more competitive in this arena.

Larger players (in terms of market share) benefit from the network effects inherent in this space, as Google has shown. The combined MSFT-YHOO entity would control 32% of the worldwide search market, compared with roughly 54% for Google, based on March numbers. So it gets them a little closer to Google’s market share, but still a distant second.

The ability to spread the operational infrastructure across a larger base of users is a powerful force; the broader the network, the more valuable that network becomes. As goes Metcalfe’s Law, the value of a network is proportional to the square of the users in that system (i.e. n-squared). Google is the most popular search destination, but also boasts a huge network of third-party sites on which to place ads. Yahoo has the most popular online “portal,” but has not been as successful at monetizing its position as has Google. There’s not much to say about Microsoft.

That said, the result of combining Microsoft and Yahoo’s online advertising capabilities will be a more robust platform for advertisers, but likely won’t change much for users of their sites. I think an integration of some sort makes strategic sense for both parties. But what makes more sense to me here is a joint venture, not a merger. With a merger, the two companies would have a difficult time integrating the two cultures. Certainly that is one of the strengths of Google – a culture that encourages innovation in this space. Trying to put together two disparate cultures into one company would likely be to the effort’s detriment.

This is a situation that certainly bears watching: (formerly?) sworn enemies taking the “lesser of two evils” path to gain some ground on Google. Even if today’s speculation comes to fruition, I don’t think Google needs to be shaking in its boots just yet.


Full disclosure: Long MSFT.

Dell Up, Let’s Upgrade It!

22 Nov

Yesterday, Dell (DELL) released its preliminary results from the third quarter. Revenues and earnings came in above expectations. They’re making progress on the customer service issues they’ve had. And their international businesses performed well, growing much faster that the overall industry in those countries while gaining market share.

Today, Bear Stearns and Needham upgraded Dell. With these actions, they’re telling their clients that, since the stock is up and the future seems clearer, now is the time to buy. In other words, “Wait to buy it until it goes up.” This is the exact opposite of when an analyst should be recommending a “Buy.” I’m glad I don’t have an account with them.

These analysts wanted to see evidence that a turnaround is in place before issuing the upgrades. This C.Y.A. mentally may have cost their clients a great opportunity, as Dell is a company whose stock over the past few months has presented a tremendous value. And today it’s up around 10%. Where were the “buy” ratings before? Unfortunately for the firms’ clients, waiting until the point when everything is clear can reduce the eventual profits they earn. Uncertainty creates opportunity.

Dell will continue to invest in customer service, new product introductions, and international expansion. In the press release, management says future operating and financial improvements will be “nonlinear.” This simply means that capital expenditures will sap some near-term earnings and cash flows. As a long-term investor, I feel great when a business invests in its future growth, especially when incremental investment returns are as high as Dell’s. Managing with too much focus on the short-term can impair a company’s competitive advantages and be detrimental to shareholders.

Dell is generating massive amounts of free cash flow, enjoys 40%+ returns on equity, has almost no debt, and carries significant insider ownership. The company finished the quarter with almost $12 billion in cash – this amounts to 20% of Dell’s market value as of yesterday’s close. There is still quite a bit of upside from here.

Disclosure: I own shares of Dell.

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