I’m from San Francisco, home to more startups and technology companies than any other city in the world. Incidentally, San Francisco and the greater Bay Area, also known as, “Silicon Valley”, is credited for creating one of the largest stock market bubbles in history. With their spectacularly high valuations, unpredictable growth, and propensity for disruption, it comes to no surprise that risk-averse value investors shy away from technology companies.
“I’m no genius. I’m smart in spots—but I stay around those spots.” — Tom Watson Sr., Founder of IBM
Buffett calls it, his circle of competence. He’s aware of what he knows, and he’s content to make his returns within those parameters. It’s not that technology companies are a poor investment, it’s just his way of avoiding errors of over confidence in a field that’s not his forté. Does it mean you should stay away too? Not necessarily. In this post, we’re going to explore some of the ways other members of the value investing community think about and make their own investments in technology companies.
Wanted: Long-Term Prospects and Stability
In the 1978 Berkshire Hathaway letter to shareholders, Buffett wrote down the four fundamental traits he looks for in a good company:
We get excited enough to commit a big percentage of insurance company net worth to equities only when we find (1) businesses we can understand, (2) with favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively.
You could say, that these are all essential traits to look for in a business, but the two of particular relevance to the discussion of technology companies are: long term prospects and stability. One way investors like to consider the long-term outlook is to pretend that upon taking a position, you couldn’t sell for ten years. Would you still buy the stock? If the answer is yes, then there must be some compelling evidence of long-term prospects. A perfect example of this would be, Coca-Cola. I’m don’t know what the world will look like in ten years, or what cell phone we’ll all be using, but I’m confident people will still be drinking Coke.
Here’s another mental exercise. Regarding a company’s stability, think of the company as you would a friend. Let’s say you loan two of your friends $100. The first one makes four, on-time, even payments of $25. The second one gives you $5 today, $30 in a week, nothing for a month, then the remaining $65. Both repaid your loan, but which one would you rather loan to again? In the mind of investors like Buffett, stability means predictable profits, and predictable profits means increasing intrinsic value.
By nature, young tech companies generally lack both of these two critical characteristics. On top of that, they’re frequently doing business in an industry that requires a Ph.D in electrical engineering from MIT to comprehend. The pace of change is so fast, that predictable, stable returns, and guaranteed long-term market share is a rarity.
Buying the Users of Technology
There are of course, ways around this problem. One such example is to look for companies which benefit as a result of Moore’s Law, in which the speed of computing increases while the price declines. Jeff Auxier, CEO of Auxier Asset Management, says that instead of making direct investments into technology, he looks for technology users.
Now, where we do like technology is like we have Visa [V] and MasterCard [MA]. They’re users of technology. We like processor companies, they’re users. And we had a lot of First Data before it was taken over. But they’re a beneficiary of all these technology prices, the prices coming down. But we’re not that comfortable with direct ownership in that space because it changes too fast.
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Buying users of technology instead of producers is one way to capitalize on innovation. Another possible approach is to consider the intellectual property or patents of the technology company and use that as a solid foundation for forming a valuation. Either way, there’s still some underlying risk that goes with uncharted territories.
Buying Products That Scale
One of the biggest things that the 90’s internet bubble demonstrated was the power of businesses with products that scale. Although many of the dotcom darlings ultimately ended up going bust, companies like Google, Amazon, Microsoft, and Apple, all survived and are continuing to grow their markets, products, and services. It’s the upside of potentially exponential growth that attracts so many investors into technology.
Paul Graham of Y Combinator and Marc Andreessen of Andreessen Horowitz are two of the biggest names in early stage technology company investing. Other notables such as, Peter Thiel of Clarium Capital and Chamath Palihapitiya of Social + Capital, manage their own VCs as well as hedge funds. In one of Paul Graham’s famous essays, he shares his advice for picking winning companies:
To be a good angel investor, you have to be a good judge of potential. That’s what it comes down to. VCs can be fast followers. Most of them don’t try to predict what will win. They just try to notice quickly when something already is winning. But angels have to be able to predict.
Interestingly, even though Paul Graham invests early and on the private side, he echoes Buffett’s desire for predictability. Is it entering the realm of speculation? Possibly–tech companies have a much steeper uphill battle to stable profits and long-term prospects, than others with tried and tested business models. Does it mean you can’t apply the techniques of value investing to technology companies? Of course you can. Ultimately, what it comes down to is buying some set of future outcomes for a price. The same four characteristics that make Coca-Cola a great business, would also make a spectacular technology business.
Niraj Gupta: How to Value Invest in Tech Companies
Robert Hagstrom: Is Amazon.com a Technology Company or a Retailer?