Looking For Value Beyond The Faded Stars Of Tech

Submitted by Covestor as part of our contributors program
By: Barry Randall

What is it about tech stocks? Why do we care so much about them? And in particular, why do we care so much about tech stocks that aren’t merely past their sell-by dates, they’re practically publicly-traded Superfund sites? Let’s round up a few of these war horses:

Microsoft (MSFT), the software behemoth that in the past 10 years spent $79 billion on research and development and came up with exactly one interesting product: Kinect. And just one problem with that – Kinect is part of Microsoft’s xBox effort that has never been profitable. Total annualized return over Microsoft’s last 10 full fiscal years? +2.9%, and most of that from dividends.

Cisco Systems (CSCO), once famous for obnoxiously beating earnings estimates by exactly one penny for years and years, now facing the existential threat of Software Defined Networking. Total 10-year annualized return? +3.0%.

Hewlett Packard (HPQ), whose demise is particularly fascinating to watch. A giant technology mastodon stuck in a tar-pit of trophy CEOs, technical hubris and congealed legacy. Remember the hand-wringing angst surrounding then-CEO Carly Fiorina’s decision to acquire Compaq?  That seems so 2002. Total annualized return since then? +2.9%.

Dell. Not even the return of its namesake founder has stemmed the dismal tide sweeping Dell toward the glue factory. Want a Dell tablet? Yours for only $759 MSRP. Smartphones? Nah. The Cloud. Eh, maybe. Total annualized return in its past 10 full fiscal years? -9.4%. Ouch.

By comparison, the S&P 500 annualized total return over the past 10 years has been +7.5%.

Of course, not all technology companies have sunk so low. IBM (IBM) stands as an exemplar of how to not merely be huge and survive, but thrive. At some point in the lengthy tenure of then-CEO Samuel Palmisano, Big Blue discovered that along with making computers and buying software companies, they could also manufacture earnings.

Witness IBM’s recently announced 3rd quarter, where revenue declined 5% year-over-year yet non-GAAP earnings per share rose 10% over the same time period. How did that happen? By trading cash for a) high-margin software companies and b) their own shares. IBM has bought back 50 million shares in the last year alone, causing its share count to decline about 4% in that time. IBM was $75/share ten years ago. It’s a little more than $200 as I type this.

Unsurprisingly, the four aforementioned companies, along with Oracle (ORCL), have attempted in the past few years to mimic IBM and its success. They’ve become one-stop vendors for hardware, software and services. Oracle bought Sun Microsystems. Dell bought Perot Systems. Hewlett Packard bought Electronic Data Systems.

But that kind of “systemic” transformation requires more than a checkbook. It requires management skill. Is that at hand? Hewlett Packard has churned through CEOs like some kind of organizational wood chipper. Currently at HP’s helm is former eBay CEO Meg Whitman, who unforgettably characterized her tenure at the on-line auction giant by stating that “a monkey could drive this train.” They say it’s better to be lucky than smart, but what if evidence suggests, as it does for Ms. Whitman, that you might be neither?

Real technical innovation is happening outside of traditional (read: “electronic”) technology. In Biotechnology. In robotic medicine.  In energy (fracking). In specialty chemicals. But the poor investment returns of our four examples are probably due in large part to these firms’ utter lack of innovation. None of our four companies has distinguished themselves in recent years. They’ve spent unwisely on R&D, and have instead ridden early leads (Microsoft), purchased others’ innovative products (Cisco) or spent virtually nothing at all (Dell).

But innovation is what allows a company to have higher profit margins, because it means they alone possess something useful, novel and non-obvious (the three elements of a patent claim, by the way) and can therefore charge more for it.

Did investors ever really care about Dell because they were spending an average of 1% of revenue on research and development every year? Heck no. They cared because Dell was a tech stock and was going up like a bottle rocket in the late 80s and early 90s. Now? Dell is just an industrial supplier (yawn). But still, Maria B. wants to break into her regularly scheduled programming to give you the earnings numbers.

As a technology fund manager, I’m immensely glad that the media still cares about these old ponies, inasmuch as it keeps my competitors’ money tied up in under-performing assets. We own IBM in the technology portfolio we manage on Covestor, and we’re always on the lookout for companies that are low on fame and high on cash flow – as opposed to these former stars, now trading on long-ago glories.

Who will be tomorrow’s war horses? Apple?  Intel? Facebook? Oracle? List your favorite in the comments below.

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