by Joe Lan, CFA
The technology sector is an extremely fast-changing sector where products, companies and ideas never stay on top for long. In the past 20 years or so, we have seen the rise of personal computers, the Internet, ultra-mobile devices and cloud computing and each of these changes has generated substantial profits for the companies lucky enough to be first to market. These technology trends have also profoundly impacted our economy, completely altering the way people live and do business and breaking down long-standing barriers to entry.
Over the past decade, the list of the largest companies in the world gradually shifted toward technology-focused companies. In fact, as of the end of 2013, three of the largest four companies in the world by market capitalization are technology giants Apple, Inc. (AAPL), Microsoft Corp. (MSFT) and Google Inc. (GOOG). In addition, new and exciting companies such as Facebook Inc. (FB) and Twitter Inc. (TWTR) are completely revolutionizing the way people communicate and the way information is distributed. It is hard to imagine technology’s role decreasing in the near future.
It is with this in mind that the inaugural electronic issue of Computerized Investing launches with a new series: Tracking the Tech Sector. Each sector of the market has unique characteristics that drive the valuation of companies within it. The technology sector is no different. The sector’s industries include semiconductors, computer services, software and programming, and computer hardware, each of which has its own unique characteristics. Additionally, various companies within each of these industries compete directly with each other. Our new Tracking the Tech Sector series is aimed directly at researching and analyzing the industries and companies of the technology sector.
The major technological advances mentioned above have each had significant effects on our economy and the way businesses are run. The rise of personal computers changed the way people communicate, increased business efficiency and productivity and created a number of new industries. The ubiquity of the Internet broke down a number of barriers to entry, such as visibility, making it much easier for smaller companies to compete with large brick-and-mortar establishments. Now, the meteoric rise of ultra-mobile computing is once again redefining the way people communicate and gather information, allowing users to access the Internet and computing power almost anywhere. Going forward, the proliferation of the cloud will reshape the way businesses are run, allowing people to store and access information almost anywhere and enabling multiple people to work on projects simultaneously.
Each of these fundamental shifts in technology broke down competitive barriers that firms faced. Information is now free-flowing—easily available to businesses and consumers alike. Companies no longer require large brick-and-mortar stores to be competitive, greatly reducing start-up costs. However, new competitive challenges are now springing up for some industries in the technology sector, such as shorter product cycles and a greater emphasis on intellectual property. CI’s Tracking the Tech Sector column will closely explore the unique challenges facing technology companies.
When evaluating tech companies, a few unique metrics are commonly used. Factors such as book to bill, strength of intellectual property and switching costs are especially important when researching companies in the technology sector. Here we give a quick introduction to each of these metrics, which will be referenced frequently in future Tracking the Tech Sector columns.
The book-to-bill ratio compares orders received to units shipped and billed for a specific period for a company. This ratio is used frequently in analyzing technology firms, specifically those in specializing in hardware such as semiconductors. A book-to-bill ratio greater than 1.0 means that more orders were received than shipped and billed during the period, a sign of strong demand. Generally speaking, a book-to-bill ratio over 1.0 is a good sign for technology companies. Of course, there are negative implications if a firm’s book-to-bill ratio is consistently above 1.0, possibly that the company cannot keep up with demand and may be losing opportunities (or needs to expand in the near term).
Strength of intellectual property refers to a company’s patents, copyrights, design rights and trademarks, as well as more qualitative factors such as pool of talent, ability to create in-demand products and perception of quality. Often, the value of a technology firm is predicated almost exclusively on these intangible assets. Companies with strong intellectual property are generally market leaders with the ability to charge a premium for their products, leading to stronger margins. Additionally, these companies tend to continue to attract the most talented individuals.
Switching costs are the negative monetary, psychological or effort- and time-based costs consumers may incur as a result of changing brands, products or services. A number of firms have been successful at creating such strong ecosystems that customers do not want to incur the time and expense to switch to a competitor. For business, Oracle Corp. (ORCL) is a great example of one of these companies: Businesses that rely on Oracle databases are reluctant to consider other options, due to the potential trouble or disruption associated with moving to a different database provider. One the consumer side, Google has done a great job integrating its services into its operating system so that customers have a hard time switching operating systems (Apple has achieved this as well).
Tracking the Tech Sector
Investing in technology companies presents unique challenges, but can be very rewarding. Companies such as Apple and Amazon.com Inc. (AMZN) that have been at the forefront of change have become leaders in the technology sector and their shareholders have been greatly rewarded over the years. Over the last couple of years, companies focusing on social media, such as Facebook and Twitter, have gained in size and prevalence. Many social media companies have gone public, or have been bought up by larger technology firms. One example is the messaging service WhatsApp, which was recently acquired by Facebook for $19 billion. The ones that are trading in open markets tend to have very high valuations, leading to debates on whether we are seeing the forming of a social media bubble.
The goal of the Tracking the Tech Sector column is to address the unique elements and challenges associated with investing in the technology sector in order to provide a better understanding of the characteristics of strong technology companies and the factors that drive their valuations. In addition, we will closely examine specific industries within the technology sector such as semiconductors, computer hardware, software and programming, and computer services to understand their uniqueness and the types of companies represented in each industry.
In each quarterly CI Tracking the Tech Sector article, we will delve into one industry in the technology sector as well as the direct competitors within that industry. We will start by examining the industry as a whole and define some factors and metrics most relevant to that specific industry. We will then evaluate companies based on metrics specific to the industry as well as broader data points used in the analysis of all companies, such as growth, valuation and momentum.
As we move forward in the series, companies that CI researches and that are deemed industry leaders will be tracked in a technology “tracking portfolio.” Our hope is to eventually create a tracking portfolio of the strongest and most influential companies in the technology sector. In addition, we want to give our CI subscribers a more in-depth look at the leading companies within various technology industries.
Investors often look to the NASDAQ composite index as a measure of the technology sector, but less than half of the companies in the NASDAQ composite are actually technology companies. Aside from the NASDAQ, there are other technology indexes, but many of them include hundreds of companies. While these indexes may be suitable for some investors, CI’s technology tracking portfolio will provide a more concentrated look at the leaders of the technology sector. We will discuss the characteristics that make these companies market leaders, and our tracking portfolio will allow us to follow their performance over time.
The new column will begin in earnest in May and continue on a quarterly basis. We are looking forward to sharing our thoughts on the technology sector with you and hope you’ll enjoy coming along for the ride.