Thursday, April 24, 2014

Two Grenades.  In which I throw two grenades square into the public square of conventional wisdom.

Value investors don't usually like tech stocks.  They like durable businesses. Technology shifts quickly; once dominant franchises are utterly destroyed in months.  (Blackberry, Nokia, MySpace, AOL Online, Dell computer, Kodak, the list is long.)

So when a tech stock finally gets "cheap," with a lot of cash flow and cash piling up on the balance sheet, value investors are tempted to buy them.

I am going to argue two positions.

1. Successful tech stock investing is done when the stocks are dear, not when they are cheap.
2. Tech companies should not get credit for huge piles of cash on their balance sheets.

Let me take the second argument first.

Apple has had billions of dollars in cash on their balance sheet over the last decade as the company has become a success, first with the iPod 13 years ago, and then with the iPhone seven years ago.  Seems like just yesterday that Steve Jobs was introducing this special iPod with internet access; now iPhones are a requirement of daily life.

Tim Cook, CEO of Apple, just said that outgoing CFO P. Oppenheimer was one of the greatest ever, having amassed a perfect ten year record of always meeting guidance.  How did he do it?  By sandbagging guidance so ridiculously low every quarter that it was useless for analysts.

What else did the CFO do that was disastrous?  Instead of using the excess cash to buy back stock when it was $100 per share, and even $200, $300 per share, he let it pile up.  What did he earn on that cash?  Nothing.  This was during the period of lowest interest rates in our lifetimes.

It was the functional equivalent of Apple requiring stacks of $100 bills under every software engineer's desk instead of table legs, to hold up their desk.  It was if the HQ of Apple was built out of c-notes instead of brick.

A company that sits on cash for a decade is implying that they NEED that cash to do business.  Even casinos don't keep this much cash laying around.  And how attractive are businesses that require billions of dollar in cash to operate?  Not very.  Ask Warren Buffett about this.

Definition of a good business:  a business that takes very little capital to create tremendous profits.

So I know what you're thinking- "well, Apple stock did pretty well all that time."  Sure, they did.  But they peaked at $702 almost 2 years ago and are still 20% below that level while the S&P is up about 30%.  Imagine what Apple stock would be trading at now, if the CFO had dollar-cost averaged that cash in along the way, like individuals are supposed to do with stock market investments?  The math is simple- the stock would be double the price it is at today.

There are countless examples of tech companies that are successful, pile up cash, and instead of admitting that they don't need that much to operate, blow it on bad acquisitions.  So at least Apple didn't do this.

So CFO Oppenheimer is not a complete value destroyer, only partially one.  So not a thief, just incompetent.

So tech companies DO NOT get credit for cash.  You CANNOT say "well, AAPL stock is trading at 8x p/e ex the cash."  That's like saying a company is trading 8x p/e ex all the needed capital equipment they need to run the business.

Let me use one last analogy.  If you were going to open a frozen yogurt shop in NYC and you needed a business loan, and got one for $20k and made $100k in annual profits, that would be a pretty nice little business.  If I ran the exact same business, but instead I needed $120k business loan, because I wanted to keep $100k in the safe just to feel better, and did the same $100k in profit, I think we could agree that would be a terrible business.


OK back to the first principle: quite simply, you can't make big money in cheap tech stocks.

The list is long.  In every single super growth story in tech, the stock was trading at a high multiple during the growth phase, and then once the multiple was cheap or the same as the S&P, the stock no longer went up.  CSCO, MSFT, AAPL, GOOG, ORCL, TSLA, AMZN; the list is long.

I'm not saying you have to buy dream pie in the sky tech stocks to make money.  But to make the real money, the big, long term, stock up 500% over a few years money, you have to buy the stocks when they are at above market average multiples.

Buying "cheap" tech?  Well, you can do it for a trade, I'm sure.  But then if you are trading ups and downs within trading ranges, just trade commodities and save yourself the work of listening to conference calls.


Tech stocks become cheap because the growth prospects are gone and they are market or GDP growers.  AAPL grew revenue by 4.7% last quarter.  The multiple is 12.  When it was still growing 60% per year it had a 45 p/e.

Yes you can find exceptions- of course!  But in general, do not get lured in to buying cheap tech thinking it will work.  You can make market-like returns, but you will never make huge returns buying cheap tech stocks.

Many investors mistakenly buy broken cheap old tech like IBM or CSCO because they remember the glory days when everyone was making double their money every couple of years in the stocks.  If you were not invited to the wedding, don't go to the funeral!

As a tech investor, I must be paid for risk.  Tech stocks will ALWAYS be riskier than other stocks because their franchises are rarely durable.  Rock solid platforms become obsolete.  Who would have dreamed Microsoft Windows would not be the dominant computing franchise?  Who would have imagined that a web site started in a dorm room would have a billion users and be threatening TV for ad space?  Who would have thought 2 Stanford grad school students would create a web site that would destroy the newspaper industry?

Tech investors need to be aboard huge, insanely successful enterprises. Examples from the past are DELL, CSCO, MSFT, AAPL and recently TSLA and FB.  Bigger risk, must have bigger potential reward.

I invite your comments, gripes and rumors.

1 comment:

  1. I would suggest that Apple's investments in their supply chain allowed them to build that huge cash pile. And once that cycle was complete, they did act fairly quickly to deliver cash to shareholders. Gruber makes a solid point:

    "[...] it seems clear to me that however superior Apple’s design is, it’s their business and operations strength — the Cook side of the equation — that is furthest ahead of their competition, and the more sustainable advantage. It cannot be copied without going through the same sort of decade-long process that Apple went through."