The Two Truths of Tech Investing

As a technology investor, I've become comfortable with two truths:

  1. My best ideas will always be under assault from something newer.
  2. Occasionally, these newer ideas will overtake my best ideas.

A great idea ... destroyed
Here's an example: In the '90s, I bought stock in Sun Microsystems (Nasdaq: JAVA  ) as a then-employee. I strongly believed in the company and its network-aware Java technology, as I still do.

But when I left Sun in 1998 and began to let a 20-bagger slip away, I misunderstood the two most important threats to its business, only one of which had to do with its once-mortal enemy, Microsoft.

First, the Solaris operating system for Sun's servers was under assault from more lightweight alternatives Linux and Windows NT. Solaris was -- and arguably still is -- the better technology, derived from the Unix kernel that has dominated network computing in most forms since the 1970s.

Yet before 2004, Solaris was expensive. Linux wasn't. Thus, when Red Hat (NYSE: RHT  ) came to be in 1995, prosperity for the upstart followed.

Second, while Sun's servers were generally equal to or better than alternatives from top rivals IBM (NYSE: IBM  ) and Hewlett-Packard, a newer, thinner, and (most importantly) cheaper box was emerging that would disrupt these massive, code-crunching engines.

Well, not the box so much as clustering and other software that would allow dozens or hundreds of cheap machines to combine and replicate, or even outdo, the big boxes. Dell would be a benefactor of the shift, as would upstart chipmaker Advanced Micro Devices (NYSE: AMD  ) , which was squeezing more horsepower into its server processors.

What's happened to Sun's stock since Red Hat's early days? This.

Shift your paradigm thinking
Talk about scary. That's why tech investing never has been, and never will be, for the faint of heart.

Though tales of garage geeks overcoming incredible odds to create the Next Big Thing are largely overdone, there is a history of people such as HP founders Bill Hewlett and Dave Packard and Google (Nasdaq: GOOG  ) founders Larry Page and Sergey Brin starting from meager means to subvert enormous and established corporations. That's why we, as tech investors, need to understand the risks and constantly evaluate the competitive landscapes and emerging technologies in the industries from which we hope to profit.

Be a better tech investor
My fellow Motley Fool Rule Breakers growth-stock analyst Rick Munarriz recently argued that one needs to ask only two questions of potential hypergrowth stocks:

  1. What can go wrong?
  2. What can go right?

While knowing your potential downside and upside and the probabilities of each are key to investing in high-growth concepts, a high-growth scenario -- to my way of thinking - dictates at least two more questions:

  1. Who will benefit? With Linux, Red Hat was the obvious choice. But with servers shrinking and clustered networks rising as the result of a cheap, functional server operating system, astute investors may have also forecast a rise in data storage demand -- leading to market-beating investments in EMC (NYSE: EMC  ) or Network Appliance.
  2. Who will lose? Linux led to a rapid rise in open-source ideas and, in contrast, a sharp rebellion against anything proprietary. Microsoft had something to lose as a result of this shift in attitude, but not nearly as much as Novell (Nasdaq: NOVL  ) . Shorting this once-dominant supplier of the NetWare OS in the mid '90s (and maybe again near the top of the tech bubble) would have been a hugely profitable move.

There will be winners and losers
Tech investors love to talk about paradigm shifts. Yet most of us have no idea who coined the phrase or what it means. The answer is philosopher and science chronicler Thomas Kuhn, in a 1962 book called The Structure of Scientific Revolutions.

Kuhn argued that when enough anomalies emerge to challenge an established scientific principle, a crisis occurs. Resolving the crisis results in a "paradigm shift," or the adoption of new thinking.

As a result, a paradigm shift is as much a threat to someone as it is an opportunity for someone else. Hence, my two questions. Asking and answering them can be an important study of how current thinking affects the stocks you already own or, better still, the stocks you wish to own. Remember:

  1. Your best ideas will always be under assault from something newer.
  2. Occasionally, these newer ideas will overtake your best ideas.

Go for growth
We suffer these inconvenient truths at Motley Fool Rule Breakers because we know that by finding and investing in technology's tectonic shifts before the broader market does, we'll more than compensate for any losses we endure.

And although our portfolio has failures alongside our successes, our collection of hypergrowth stocks is 10 percentage points ahead of the market on average. To see the companies that we think will be the next great tech stocks of tomorrow, click here to join Rule Breakers free for 30 days. 

Fool.com and Rule Breakers analyst Tim Beyers owned shares of IBM at the time of publication. Dell and Microsoft are Inside Value picks. Dell is also a former Motley Fool Stock Advisor selection. The Motley Fool's disclosure policy rules at Truth or Dare.


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