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August 23, 1997 |
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I awoke at 6:30 a.m. on this Saturday morning. I couldn't go back to sleep as my body is accustomed to getting up at around this time, so I decided to catch up on my backlog of reading material. Forbes magazine's issue was titled "Silicon Wealth Explosion", BusinessWeek's recent issue had "Silicon Valley/How It Really Works" screaming out from its front cover, and another magazine sent me a Special Bonus Issue titled "Investing in Technology". It is obvious that technology has become so integral to the economy that all the major business magazines are devoting entire issues to the subject and how to profit from it. Change Is Constant Technological innovations create changes on both a macro and micro level - they impact the overall economy via the changes they create on the individual business level. In the 1930s, economist Joseph Schumpeter stated, "Capitalism is by nature a form of change and never is, never can be, stationary." According to Schumpeter, every 50 years or so, waves of technological revolutions would cause gales of creative destruction in which old industries would be swept away and replaced by new ones. I believe the cycles of technological revolutions have been shortened considerably in the last few decades. The gales of creative destruction have definitely been happening with more ferocity and frequency in the past decade. What impact do such technological revolutions and the resultant changes have on me as an investor? How does it affect my selection of companies and businesses for investments? Will my investments benefit or lose from such technological changes? My mind started to ponder these questions. Change And Investing Is change (be it technological or otherwise) good for investing? To the extent that change makes it more difficult for an investor to judge the future of a business with certainty, it is bad for investing. The less certain the future, the higher the chances of investment error. When I invest in a business and take a long term view, one of the most important judgments I have to make is how the business will perform ten years down the road. This is a very difficult judgment to make under any circumstance but the difficulty increases substantially nowadays with technology permeating virtually all aspects of business. Very few businesses are untouched by technological changes and such changes may have a material impact on the future of the business. However, even though change is constant in capitalism, different businesses are affected by technological changes to different degrees. The key is to try to figure out how the business I want to invest in will be affected by technology and then decide whether I have an edge in investing in such a business. I believe there are three broad categories of businesses, and that each is impacted by technological changes differently. Businesses That Surf The Wave These businesses are directly affected by changes and innovations in technology. They are the high-tech businesses, characterized by fast-moving markets and short product-life cycles e.g. Cisco, Intel, Microsoft, and Oracle to name a few. Each wave of technological changes produces new winners and losers. If a company is fortunate enough, whether by luck or design, to get onto a new technological wave early on and ride it successfully, it can produce big profits. Investors who get into the company early in the wave will have huge wins as well. Technological revolutions in any field provide opportunities for new competitors to start at the same block as the previous leader. A lot of the competitive advantages of the leader have much less of a stranglehold in the new markets created by technological revolutions. For example, Netscape came from nowhere and quickly dominated the Internet browser market (at least for now). Sometimes being the leader in the previous generation of technology can actually be a handicap (think IBM). There are strong parallels between the ecological and business world - organisms that are conditioned to survive and flourish in one environment frequently perish when their environment changes. This is why strong, established technology businesses can be unseated by a new business started by two guys in a garage somewhere. With the pace of technological changes in the last decade, the waves are getting shorter and shorter. A company surfing a wave must know when the wave is ending, when to jump off this wave and try to catch the next wave. If the company fails to jump off and catch the next wave in time, then its prosperity will be short-lived. The technological landscape is littered with such wave crashers, e.g. Wang Computer, Apple Computer, and Novell. Investors in the technology business, or in businesses that are substantially affected by technological changes, must therefore recognize that rapid, violent change is a constant. Sometimes the changes can be beneficial, but most often they are detrimental. If you are buying and holding for the long-term, then either you have to be able to recognize the changes yourself and know when to jump off that wave to catch the next one, or you have to find management that has the ability to do that. Both are very difficult to do. Remember how late Microsoft was in discovering the Internet - 1995. Netscape wouldn't even exist if Microsoft had been awake. To Gates' credit, when finally he did wake up, he turned the whole battleship around to focus on the Internet. But this is a very rare instance. Consider this - if a person with the IQ of Bill Gates, and who breathes technology every day, initially misses the Internet, what are the realistic chances that I'll be able to surf the wave better than him? Mind you, I am not advocating against investing in the tech business. I am just saying that I don't think I have any edge in this area. Businesses In The Eye Of The Hurricane It is always the calmest in the eye of the hurricane. Businesses in the eye of the hurricane are those that are relatively insulated from the technological changes going on around them because of the nature of their industries and their dominance. Who will be the dominant soft drink company or the biggest chewing gum company in the world twenty years from now? Who will be the dominant software company in this planet ten years from now? I can answer the first question with a degree of certainty, i.e. Coke and Wrigley are the two companies. However, I don't have a clue as to the answer to the second question. I don't think even Gates can answer with conviction that it will be Microsoft. Of course he will definitely break his back side to try to continue Microsoft's dominance. If the management of these "eye of the hurricane" businesses continues to make the right moves to protect and grow their franchises, then their prosperity will continue for many years to come. No amount of technological change will be able to unseat Coca-Cola. In this year's annual meeting of Berkshire Hathaway, Warren Buffett remarked that he would not have a clue how to take on Coca-Cola even if someone was to give him $100 billion dollars. Investors will be able to make very substantial profits in these businesses if they get in at the right price. When you own a Coke or a Wrigley or a Gillette, you don't have to worry about the two guys in the garage. Businesses With The Wind Behind Their Back I believe there are businesses that will benefit from technological changes. These businesses are fortunate enough to be in a position such that technological changes will be like a tail wind - their performance will be boosted by each wave of technological innovation. For example, technology may lower distribution and selling costs and/or create new markets or customers. At the same time, the original competitive advantages of these businesses are not eroded by technological changes and may even be enhanced by them. The net result is like a strong tail wind behind the back of these businesses, enabling them to run faster than they normally can. I am currently evaluating a few businesses that may have such potential (no conclusions are drawn yet). The main difference between these "wind behind their back" businesses and the high-tech businesses is that the former are not surfing a wave. Unlike the tech businesses, these businesses will still perform well even without the winds of change. The extra wind only serves to enhance their performance. Sorting Them Out I ask myself the following questions when trying to determine what category the business I am evaluating is in : 1. Is the basic nature of the business prone to drastic changes (be it technological or other changes)? Competitive advantages are hard to maintain in businesses that are rapidly changing all the time. 2. In particular, will technological changes have any impact on the basic nature and competitive position of the business? 3. If there is an impact, is the impact positive or negative on the business? If I cannot form a judgment on this then I'll just move on to the next business. 4. If the changes are positive to the business, will the benefits be reaped only by the business in question or will its competitors share in the benefits as well? In a war, one side has an advantage only if that side can obtain superior weapons that its enemies cannot. If the weapons are available to both sides, then competitive advantages will be achieved by the side that can get their hands on the weapons faster than the other - the ability to run just a tad faster than your opponents via insight, speed, and execution. Stick To Your Edge As an investor, where you decide to play really depends on your own experience, competence, and temperament. If you know high tech, then by all means stick to that game. Indeed, investors like Roger McNamee have done exceptionally well in tech investing. For me, I do not know how to play the high tech game and prefer to concentrate looking in the second, and especially, the third category. There are indeed many ways to heaven. |
