Everybody loves a good story. It is part of human nature and unsurprisingly carries into the behaviour of investors. Most market participants are continually searching for the ‘new best thing’. As a result, yesterday’s ‘best thing’ is often an unloved, undervalued, attractive investment opportunity.
While I am sometimes surprised at how long it takes investors, and therefore share prices, to reflect that business models are no longer fit for purpose (witness UK food retailers as a recent example), I am far more often confronted with the case of a business being assumed to be in much quicker decline than is realistic.
This can provide a happy hunting ground for value investment. When a business valued for rapid decline also has an overlooked growth investment opportunity, the case for inclusion in a portfolio can become compelling.
Successful management teams will be aware of developments in their industry and the threats these developments pose, and will formulate a policy to embrace them, mitigate them or manage the decline they inflict. By the time equity market participants ‘discover’ the threat, a good man-agement team will already be investing the company’s cashflow into a new growth area.
When the market starts to value the firm on the operations in decline, the contrarian value investor can buy shares in anticipation of the market’s discovery of the new growth engine and benefit from the subsequent re-rating of the shares.
Opportunity in arrogance
While this ‘out with the old, in with the new’ attitude pervades the market, no¬where is it more emphatically pursued than in the technology arena. Here, brilliant an¬alysts spot the disruptive innovations of which they believe incumbent technology company managements are oblivious. This degree of arrogance provides opportunity.
Yesterday’s technology is deemed to become obsolete very rapidly and yet here we are, still with paper in our offices and fax numbers on our business cards.
A good example of this phenomenon is Intel. A business that was valued at a PE ratio in the low 20s in the early part of the century has been languishing closer to 10x in the current decade, on the basis that tab¬lets were going to destroy the company’s PC semiconductor business.
However, the company has employed its prodigious cash-flow to invest in both its data centre business, to access the growth from the cloud and big data, and its mobile business. It has also reduced its share count by 16% since 2005 and grown its quarterly dividend from $0.04 (£0.02) to $0.24.
The combined return to shareholders has been $98bn while R&D and capital expenditure have totalled $153bn. The shares have risen by 76% from a price of around $21 in early 2013 to $37.
Head in the cloud
Intel is by no means a lone example. Seagate Technology has undergone a similar transformation. The company is one of the major players in the hard disc drive market. It was therefore also set to be one of the losers from the death of the PC and had been rated as such. Not only has the PC remained more resilient than the valuation implied, but the company has not just sat idly by.
As the tablet market has grown and consumers have gone mobile, cloud storage requirements have taken off. Now, of course, data is not actually stored in a cloud; it is stored on units in a warehouse.
Who supplies these? The very company that was supposed to be in terminal decline. Post the financial crisis, the share traded between $10 and $20. This range was broken out of in 2012 and the shares now trade at pushing $60.
Of course, the normal rules of investment apply. Stock selection is crucial if you are backing a management team to recognise the threats and turn them into opportunities; not all businesses will achieve a successful transformation. However, as the market chases this year’s shiny baubles, perhaps the best thing about ‘new’ tech stories is the opportunity it brings to make profitable investments in ‘old’ tech companies.