Cruxellaneous

Porter Stansberry: This misunderstanding could be responsible for your all-time worst losses

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From Porter Stansberry in the S&A Digest:
 
In today's Friday Digest… we bring you a discussion of technology stocks. Believe me… I know most of you will never buy a technology stock again. But… hear us out. We'd wager the main problem you had before was that you weren't actually buying technology stocks at all. You only thought you were…
 
On the other hand, you certainly don't have to buy a technology company to make a fortune in stocks. (See superinvestor Warren Buffett, for example.) If you can't even stomach saying the word "technology," perhaps today's Friday Digest isn't for you.
 
We hope you'll consider this guide to tech-stock investing, though… because the highly scalable nature of some technology products can generate huge wealth for investors. Today, we're going to discuss why now is a good time to invest in technology… and how I size up tech stocks.
 
Tech stocks traded at insane valuations in the late 1990s and early 2000s. The chart below shows the average book value of the Nasdaq 100 (a top index of tech stocks). For a while, these stocks were so expensive as a multiple of their assets or their earnings, it made no sense to buy them – any of them.
 
 
Today, however, a lot of the higher-quality tech stocks have grown into very successful, real businesses… businesses that pay investors a healthy return in the form of cash dividends and share buybacks. Many of these high-quality tech names actually trade at a discount to the market as a whole. That has led various S&A analysts to recommend several tech stocks over the last year. So what, exactly, are we looking for when we buy tech?
 
Do you remember K-tel records? The company was founded in the mid-1960s by a door-to-door knife salesman, Philip Kives. His breakthrough idea was compilation albums of licensed music. The first one was called 25 Great Country Artists Singing Their Original Hits. The record was marketed via television and sold over the phone… and it was a smash success. All the other record companies soon copied the concept, but K-tel continued to have success marketing its 20 Greatest Hit compilations for decades. (The company still sells them today on iTunes.)
 
What does K-tel have to do with tech-stock investing? Nothing. That's the point. In April 1998, the company announced it was expanding its direct-sales model from TV to the Internet. The simple announcement turned K-tel into an "Internet stock." Its share price jumped from $3 to $7 in one day. About a month later, it peaked at almost $35 a share. At the time, the company wasn't profitable. It soon was in violation of Nasdaq listing requirements. Shares fell to less than $5… and by the end of 1998, its share price had completely collapsed. In 2007, it completed a 1-for-5,000 reverse-split. We couldn't even find a quote for the shares today.
 
I bring up K-tel because the No. 1 thing that most individual investors get wrong about investing in technology stocks is thinking a company is involved in technology when it's really not. The truth is, there aren't very many genuine technology companies. Instead, almost all of the companies people call "tech stocks" are really nothing more than K-tels: They are companies that use technologies to make or to sell their products. They have no real technological advantage whatsoever. As a result, it is difficult for them to achieve the kind of scalability (expanding profit margins) that is the hallmark of great tech companies.
 
Think about Dell Computers, for example. Most investors would consider Dell a tech stock. But it's not. Dell buys microprocessors from Intel, video chips from Nvidia, and hard-drive storage from Western Digital… Then, it puts these pieces together using software from Microsoft. Dell isn't a technology company. It's a very efficient manufacturer. And because it builds computers to order quickly, it's also a logistical expert. What doesn't Dell spend much money on? Research and development (R&D). Its entire R&D budget is less than $1 billion per year.
 
But R&D spending alone doesn't define a tech stock, either. Ford Motor consistently has the highest R&D spend of any American company. It's usually ahead of Intel, which is around $8 billion annually today. It takes a lot of very expensive engineering and testing to make safe cars and extremely reliable engines. But we don't consider Ford a tech stock… Why not?
 
To me, the definition of a tech stock is based on the nature of the moat that surrounds its business and protects it from competition. In short, is the company's competitive advantage based mainly on the technological superiority of its products? Are these technologies proprietary? And most important, are these products tremendously scalable? Will the gross profit margins of the business grow as volume ramps up?
 
Consider Intel, for example. Intel takes sand (silicon) and applies decades of research and engineering to turn it into the heart of the modern world – computer chips. The moat around its business is both high-tech expertise and intellectual property. It is difficult (impossible, really) to compete against Intel in the microprocessor market, where it has tremendous scale.
 
That's because most of Intel's costs are fixed. It takes a lot of capital to build fabs (the plants where Intel's chips are made). It takes a lot of capital to spend on R&D to produce faster and faster chips. And it takes a lot of money to hire and retain the brilliant engineers to design the chips and the patent attorneys to protect the chips. But it doesn't cost much at all to make each additional chip. This lack of marginal costs (and the large size of the fixed costs) is what make tech stocks so interesting for investors.
 
In the three years between 2010 and 2012, Intel's business grew – a lot. The company sold $10 billion more in chips last year than it did in 2010. But the company's costs to make these extra chips only increased by $5 billion. Thus, the more chips Intel sells, the bigger its margins get. This fact makes the microprocessor market a natural monopoly. As Intel gets bigger, it can afford to spend more and more on R&D… which makes its chips bigger, faster, and better than its competitors. The R&D makes its products better in a tangible, objective way. That, in turn, allows Intel to sell more and more chips at higher and higher prices… and earn wider and wider margins.
 
I realize the stock market hasn't been impressed with Intel's earnings lately. I think investors are making a huge mistake. Wall Street puts far too much emphasis on sales growth. It ignores the quality of a company's earnings and the moat around its business. Yes, on a percentage basis, Intel's growth is slowing because it is already such a big business.
 
But consider the quality of those earnings. Last year, Intel earned more than $20 billion in cash. With this huge profit, Intel spent more than $16 billion returning capital to its owners via cash dividends ($4 billion) and share buybacks ($12 billion). In short, shareholders at Intel kept 80% of the profits. Please make sure you understand what this means… Intel is a $100 billion business. The current shareholder yield (cash and share buyback) is now over 16%.
 
Let's compare that to Wall Street's current darling, Apple. Apple is much more like Dell – it designs consumer products that use mostly other people's technology. The big difference is that Apple is also a software company. Its software is truly excellent, so we'd qualify Apple as a legitimate technology company. The question is, does it truly compete on the basis of technology… or on the basis of design and brand? I believe it mostly competes on brand and design. Thus, it will be harder (and more expensive) than most people think for Apple to remain as dominant as it is today. It will be harder for it to maintain its profit margins because it's not competing on the basis of pure technology.
 
Apple is a $450 billion company. It earned $50 billion in cash last year. How much of that vast richness did its shareholders get? Almost nothing – $4.5 billion in total dividends (cash and net share buybacks). The company kept more than 90% of its earnings.
 
I know the market (and most of you) will not agree with me, but trust me on this… Intel is a much better investment than Apple. Intel is a real technology company. Its products are objectively better than its competitors' and that advantage is maintained via R&D spending and patents. It will be incredibly difficult for anyone to compete with Intel effectively in microprocessors. Apple, meanwhile, depends far more on design and consumer preference for its competitive advantage.
 
While I love Apple's products today, I never used them until about 2006. The public taste is fickle. It is not hard to imagine that someone… a new Steve Jobs… could come along and put together phones and computers in a new and better way. Apple realizes that too, which is why it wants to keep such a huge cash hoard (now more than $150 billion). Intel doesn't need a stockpile like that… so it can return more of its profits to its shareholders.
 
I'll let you decide which company is the "real" tech stock and which is the future K-tel. Today, by the way, investors value Apple at $400 billion (enterprise value, which doesn't include the company's cash hoard). Intel is only worth about 25% of that amount ($100 billion enterprise value). It's a safe bet that Intel's stock will outperform Apple's over the next decade.
 
You can think about a lot of other "tech" companies in this way. Consider Facebook and Google, for example. Which company is the real tech stock? I've been using Google since 2003. I've never used another search engine. I've never used another e-mail provider. Google's software is vastly superior to its competitors'. The company holds thousands of patents on this know-how.
 
What about Facebook? Is there any real technological difference between Facebook and the other social-media websites that have failed? Nothing obvious… at least, not to me.
 
Now, understand, I'm not saying that Facebook or Apple will fail. (In fact, as Digest Premium subscribers know, if its share price falls below a certain price, I might be tempted to buy them.)
 
I'm simply pointing out that they're not really tech stocks. They're consumer-products companies… and being successful in that field for long is very, very difficult. It's very hard to build a lasting moat around the fickle tastes and passions of the consumer. That's why Facebook has already had to spend $1 billion buying Instagram, a company that didn't even exist when "The Social Network" – the movie about Facebook – came out in 2010.
 
To be successful as an investor in the long run, it helps to know a lot about business… particularly about how companies maintain and grow their profit margins. Some companies rely on brands. Some companies rely on technology. I believe it's best to really understand the difference… and not to confuse the two.
 
Crux Note: Porter recently read a book that was so good, he thinks every one of his subscribers should read it. In fact, he thought it was so important, he actually purchased thousands of copies to give away... free of charge. To see why he was so moved – and to get a free copy for yourself – click here.
 
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