This week we take up where we left off regarding the seeming disconnect between the prospects of so much of the global economy represented by what investors call the Tech Sector and Market’s recent rough treatment of so many of the stocks in that sector. If you own Tech Stocks, you are all too familiar with the recent divergence of improving company fundamentals (Commercial Reality) from share prices (Price Reality). This disparity started to abate during the first days of February, but only time will tell if the Tech Stocks are leading us into a full blown and inevitable (at some point in 2010, IMO) correction (i.e., >10%) or just another pullback for the Bull to catch its breath. This disparity matters to me because I have some very large bets in place that Tech has more going for it than the proverbial dead cat bounce. After decades of erratic evolution, it appears that certain parts of the Tech Sector have undergone a fortuitous tipping point very much likely what the Aerospace Suppliers experienced almost a decade ago. Consequently, I expect that over the next few years, some of these Tech stocks to remind investors of what some of my favorite aerospace & related stocks (e.g., CRS, ESL, HEI.A, LDSH, PCP) did for us over the 2004-2007 period.
Before we delve into what seems to be a subtle yet seismic shift in where supply (or capacity) meets demand in the Tech sector, it is important to consider the competing point of view. The pullback in many Tech stocks suggests a strongly held point of view that differs from my positive assessment. Of course, the very ability to buy or sell shares dictates that somebody else, with access to the same (theoretically available) data has arrived at a conclusion opposite to one’s own. (And sometimes, they’re the ones who are right!) Opinion at the margin, in stocks that are not so small as to be “off the radar”, is generally dictated by Street, or sell-side, analysts. To the extent that their various opinions have been made knowable to me (what gets published and widely disseminated might differ from what is shared privately with favored clients, some of whom work for the same firm), one of us (me or them) is clearly missing something. Only time will tell who is closer to the truth, but consensus opinion seems driven more than anything by willful ignorance. There is a charitable understanding of the subject (ignorance), but not so much the predicate. Sometimes a change can be “too big to see”. This is especially so to the degree experience has “hardwired” one’s perceptions. The preponderance of sell-side analysts have less than ten years of experience. This means that they know only the past (“two-bust”) decade wherein the Tech infrastructure spent most of its time struggling to grow into capacity thrown up to meet the expectations that developed during the Tech Bubble. You would think that analysts who have been around for much more than a decade would have that advantage that comes with having lived through multiple cycles. That can indeed be a great advantage, but it is not unalloyed. This is because such an analyst has spent their entire adult life in an industry that from the start was grossly over-hyped and overcapitalized. Such experience would give rise to habits of thought and perception that would make it difficult to recognize if and when nature taking its course had evolved the industry into something else. In this sense, there is a charitable explanation for why leading analysts might be missing a fundamental shift in the basic nature of the businesses they have spent their lives following.
There is also a less than charitable understanding of this tied up in the willfulness by which such ignorance is perpetrated. This relates to the incentive structures and implicit terms of employment both in the Street and the financial media. As I have suggested before, one doesn’t have to believe in a nefarious “they” who manipulate or even control the markets to recognize the inevitability of unwholesome influences that accentuate volatility. Wall Street firms and media companies live and die by the reality that every day there is a story to be told. They compete for attention, and if they stop showing up with compelling stories, they are quickly crowded out by others. Every day, someone has to decide what the stories will be and what the “slant” will be. That means individuals, heads of research, editors, etc., who like any other malleable human being have needs and aspirations. This means that on any given day, “the story” will come with a slant that has at least been influenced, if not effectively determined, by someone whom such a gatekeeper is trying to please, impress or otherwise score points with. (This is probably why a century ago, G.K. Chesterton dismissed newspapers as playthings for rich men.) It should be patently obvious to anyone who has trafficked in the ebb and flow of share price volatility that there is tremendous advantage to be had in being able to influence such gatekeepers, to be privy to what the slant is going to be. Most analysts and financial journalists know, or at least fear, that they are in the best job they will ever have, and that the next step down is a doozy. Thus, they are probably a lot more susceptible to the promptings of the gatekeepers than we would like to think. So viewed in terms of a rational and utilitarian understanding of life, how surprised should we be, and how much can we blame them, that willful ignorance is coloring consensus opinion of these companies and their stocks.
So what is the basis of this “tipping point”, or, switching metaphors, sea change that this grizzled old Market observer thinks he sees? It is nothing less than a fundamental shift in those irreducibly basic determinants of commercial reality that are Supply and Demand. Like so many industries that burst on to the scene with great promise but for the first generation or so delivered decidedly mixed results for investors, Tech, or at least certain parts of it, has come of age. Gross overcapitalization has abated, and the ability to deliver a steadily improving value proposition is spurring demand at well above normal (i.e., GDP or population growth) rates. The last time I saw this was in Aerospace. Like that industry, Tech was grossly overbuilt, albeit for different reasons (dazzling future prospects v. the geopolitical necessity of standing down Communism). Both involved collaborative innovation to steadily improve the value proposition, be it the “all-in cost of travel” (time, safety, convenience, etc.) or what Moore’s Law did to the unit cost of computer power. Both address human needs, deeply rooted in “connectedness” and desire for novelty, that are coveted by a persistently increasing share of the world’s population.
Like the aerospace industry, Tech has weathered gross but steadily declining overcapacity for a very long time. (40+ VC backed HDD start-ups in the 1980s, plus in-house capacity at nearly every consumer electronics producer of note, now down to two strong companies with a 60%+ share plus three captive producers, exemplify this.) These not what the sage of Omaha would call great businesses, but they are a damn sight better than what they were, and certainly better than what an analyst who has experienced the past 10, 20 or 30 years (or learned from those who have) is likely to think they are. It is important to bear in mind that Tech is a lot of businesses, some of which will probably always be lousy (like DRAM, foundries or passive components), but others of which have evolved to near monopoly, statesmanlike duopoly, or the sort of “one big dog and one stalking horse” that, again, emerged in aerospace coming out (or perhaps just before, but we couldn’t quite see it yet) its debacle of 2001-03. The determining factor here resides in the other big driver of consolidation: high and rising barriers to entry. There will be parts of Tech that will stay commodity-like, but the parts that are “a trick to do” seem to be getting a lot more attractive. For a dozen years at least, I was beat over the head with the question of why Precision Castparts was not a commodity business. Part of the reason they are doing as well as the have in the past five years is execution, but it is also this kind of evolution in the commercial reality of the business they are in (which they had a hand in effecting). The same thing has gone on with the likes of Intel, Cymer and the two dominant HDD makers, to name a few. The barriers to entry are not just the massive expense of building plants. They are also intellectual, at least as much about process as product (very important given the cross-licensing that has been imposed by the customer base). Importantly, the collaborative innovation needed for the ongoing interplay of process and product technologies is difficult if not impossible to replicate in what have been described as “low-trust” cultures (i.e., China & India are unlikely to compete successfully at it anytime soon). Such technical progress is a steepening curve, and after a while only a very few can continue to climb. Finally, it would seem that where decades of improving value proposition have been at work, the end product has a way of evolving from a luxury enjoyed by a very few to something that is woven into the preferred lifestyle of all but the very poorest of the earth’s billions. This brings us to the demand side of the equation.
Demand for what the Tech sector delivers can be seen in the sheer growth in the amount of data that gets generates, transfered and stored. It has seemed to be steady and inexorable, but closer examination indicates discontinuity in the rate at which “digital” has been embraced as a part of how we work, play and otherwise live. This is because like any other good, it grows as a function of its perceived value, which in turn is a function of utility and price. It has also mattered that numerous technologies have had to develop, each of which facilitate the perceived value of the others. These include the devices themselves, “content”, the means of distribution (i.e., networks) and various enabling technologies that do not fit neatly into such categories. The technologies that make all this possible have developed at varying rates and with varying consistency, and the progress of the whole will be “gated” by at least one of them. Looking back, we can see this caused progress to be a bit more discontinuous than expected. For example, computing power and content had to wait on more widespread, acceptably price broadband for Web 2.0 to commence.
Viewed in this light, 2010 finds us with “all systems go” for a protracted season of strong demand for that which facilitates “things digital”. The growing robustness and ubiquity of wireless networks has enhanced the value of that plethora of hand held devices. This in turn is causing the network providers to scramble to invest in their networks. It has been helped along by advances in technologies which compress and then decompress files (like what Netflix uses so that customers with bucolic wireless providers like me can watch what seems like a streaming video). Lower cost devices mean multiple devices per household, and in many more households around the world. Content providers are responding not only to the enlargement of their markets but to the improving ease with which data can be shipped and stored, by increasing the data “richness” (bits used to produce images. I am told that whereas bit-count used to be an annoying constraint for content creators, they have in recent years exulted in being able to bulk up the digital complexity of their works.) This symphony of improving value is what has driven the breakneck (40%? 60%? Who knows, but its high) growth in demand for data storage. This growth is not a fluke, it is a host of interdependent technologies all seeming to be making enough forward progress that the value proposition will not be slowing down any time soon. This does not mean that every part of the sector will be something investors would want a part of (segments where a Taiwanese or Korean conglomerate can spend their way to market leadership come to mind), but the segments that resemble the capacity side of this discussion should do very well indeed.
A necessary part of demand worth investing in is that it can be understood in terms of addressing a very basic human need or desire, preferably as in a luxury coming to be perceived, and sufficiently available, to be a necessity. This has been the case with air travel, which in June 2003, in depths of the worst recession aviation had ever seen, prompted me to write “Not Going Back to Greyhound”. Much as air travel has become simply a part of how growing millions of us choose to live, the “connectedness on one’s own terms” made possible by the collective offering of this thing we call Tech addresses a very basic human need. It is a big part of why Tech’s ability to grow its share of discretionary and not-so-discretionary spending will persist as long as there is any forward progress in the value proposition. However, since I last posited that driver of demand, my reading has brought me to an even more basic understanding of why humans crave what “all things digital” delivers. This will most likely be the subject of the next Market Musings.
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