5 ways to spot tech's next winner

The dynamics of technology investing change constantly, and no stock -- even Apple -- is immune to the Next Big Thing. Savvy investors will approach this sector with a step-by-step strategy.

By MoneyShow.com Apr 13, 2012 4:16PM

Image: Projector © David Freund/iStock Exclusive/Getty ImagesBy Howard Gold, MoneyShow.com


This week, the news broke that electronics giant Sony (SNE) planned to lay off 10,000 people, or 6% of its workforce.


Last week, Internet portal Yahoo (YHOO) started letting 2,000 people go in another of its endless restructurings.


The week before, Research In Motion (RIMM), the Canadian smartphone pioneer, said sales of its flagship BlackBerry phone would continue to drop until at least late this year.


And in January, Eastman Kodak (EK), once a symbol of U.S. technological prowess, filed for Chap. 11 bankruptcy protection.


All these companies were once top dogs. Sony was the most cutting-edge brand in consumer electronics. Yahoo had a vast audience who used its e-mail, checked stock quotes, and read free news articles. RIM’s BlackBerry was a status symbol in corporate offices, and almost an appendage of multitasking soccer moms. And for decades, Kodak was the brand name in photography and home movies.


But then new players changed the game. So, these once-great franchises are now in deep trouble.


"In every one of those cases, there's been a dramatic disrupter whose actions at the front of the life cycle pushed somebody off at the back of the life cycle," said Geoffrey Moore, a leading consultant and strategist who has written several books about the life cycle of technology companies.


It’s called creative destruction -- the very engine of capitalism -- and nowhere does it operate with more ruthless efficiency than in technology.


It’s also what makes tech such a pitfall for investors who want to make big money on huge winners like Apple (AAPL), Google (GOOG), or Amazon.com (AMZN), but often hang on to losers far too long.


So, how do you separate the wheat from the chaff in tech? I contacted Moore, a venture capitalist and chairman and founder of TCG Advisors, for some answers.


In the 1990s, he wrote two books -- "Crossing the Chasm" and "Inside the Tornado" -- that became the bibles of wannabe Internet moguls and venture capitalists seeking to profit from rapidly growing markets.


Even though the Internet boom and bust are long gone, Moore’s principles still hold. He just wrote another book called Escape Velocity about how established enterprises can generate growth.


Moore says disruptive technologies -- like the personal computer, the Internet, or the cellular telephone -- don’t happen overnight. They first go through a long gestation period.


But if the product takes off, the company enters the hypergrowth phase -- the tornado. That’s when firms that are in the right place at the right time can grow like crazy and become the market leader for years to come.


That’s a recipe for huge revenue and earnings growth, and fat profit margins, especially if a firm has pricing power. Think Microsoft (MSFT) back in the day, or Apple now.


When companies like Google go public at the sweet spot in their growth cycle, they become "gorillas," in Moore’s phrase, or "ten-baggers," as legendary money manager Peter Lynch called them.


Other top gorillas of the past: Intel (INTC), Qualcomm (QCOM), Oracle (ORCL), and Cisco Systems (CSCO).


If gorillas are dominant companies in hypergrowth markets, established companies -- yesterday’s gorillas -- are often their prey. Kodak is a good example, said Moore. Once a dominant company, Kodak struggled in the transition to digital photography. It tried to transform itself into a digital imaging play, with some success.


But though buffeted by all kinds of competitors, its knockout punch came from Facebook. “Images became the central currency of Facebook,” Moore explained. "Kodak’s currency got radically devalued.”


It’s not that Facebook wanted to finish Kodak off, he said. "Facebook never had anything in for Kodak -- they found pictures made [Facebook] more engaging." Kodak became collateral damage, and "we eliminated an iconic company."


Yahoo faced a big challenge from another emerging gorilla, Google. Yahoo had a popular search engine for some time. But with paid search, Google created a gold mine whose growth soon outstripped that of the display ads that were Yahoo’s bread and butter, and ad dollars moved its way.


Yahoo "was set completely on its ear by Google," said Moore. "They needed to fight on two fronts -- a media front and a technology front."


"They chased the Google whale -- they were the Ahab and they put an enormous amount of money into" the strategy, he added. Result: Yahoo has a giant audience, but little growth, so it has nowhere to go.


Sony, ironically, was undermined by a technology it had developed earlier -- mobile music. In July 1979, the first Sony Walkman, a portable stereo cassette recorder, hit the streets. The Sony Discman followed in 1984.


But Apple’s iPod and iTunes completely redefined the category in the early 2000s. Convenience and portability trumped the superior sound and picture quality of home-based electronics, Sony’s strong point, and digital downloads replaced discs. Except for its PlayStations and incremental advances in unprofitable television technology, Sony hasn’t been a great innovator in decades.


Apple also cut the ground out from under RIM with its launch of the iPhone. "RIM was holding its own until the iPhone took the corporate market," Moore said. "As an enterprise play, it probably had legs, [but] Apple came and redefined the consumer space, and RIM had nowhere to hide."


So, what lessons can investors learn from this?


First, go with the gorillas -- if you’re willing to pay up. This is the Holy Grail of tech investing, and you’re going to have lots of competition.


I remember clearly how some journalists trashed Google for its valuation at its initial public offering. Yet it’s up more than sixfold, and trades in the $600s.


Facebook is expected to go public next month after a long gestation period in semi-public markets, so at least some of the value of the hypergrowth phase already may be in the offering price.


“What I would be looking at is how much would they have to grow revenues and earnings over the next five to ten years to justify the stock price?,” Moore cautions. “Do they need a net new earnings engine besides the one they have?”


“At IPO time, people get excited. That will correct over time,” he added. Translation: buy on the dips, if there are any.


Second, if you own tech stocks, watch carefully for disruptive technologies, and sell at the first sign your company is having trouble fending them off. Don’t expect established companies to prevail over innovators; they seldom do.


Third, don’t bottom fish in tech. Technology is usually not a good hunting ground for deep-value investors, and successful turnarounds are rare. [The repeatedly aforementioned Apple was a dog for well over a decade before the company switched focus, and it's such an exception to this rule, we may not see it again in our lifetimes—Editor.]

Fourth, consider buying mature tech companies that pay dividends. Income-oriented advisory services now recommend Intel and Microsoft, which have accepted they’re not hypergrowth companies anymore and started paying decent dividends.


By doing so, they brought in a new class of investors who have more reasonable expectations. Slower growing tech companies that don’t pay real dividends are the worst of both worlds.


And finally, make any tech stock -- or individual stock, for that matter -- a small part of your portfolio. Diversification is the best protection against bad judgment. In an area where there are 20 strikeouts for every home run, the race goes to the prudent, not the swift.


Howard R. Gold is editor at large for MoneyShow.com and a columnist for MarketWatch. Follow him on Twitter @howardrgold and read his political blog at www.independentagenda.com.


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