FOOL ON THE HILL
Value Investing in the New Economy

Value investing does not preclude buying technology-related stocks. In fact, such stocks can offer some of the best opportunities for value-oriented investors, but be careful -- and consider locking in some gains when your stock suddenly becomes priced as if it's taken over the world.

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By Whitney Tilson
November 14, 2000

After my overview of value investing in last week's column, today I'd like to continue with some thoughts on how this style of investing can be applied to the New Economy -- in other words, buying tech stocks. While many well-known value investors, such as my investment hero Warren Buffett, will not touch this sector (see my column on Why Won't Buffett Invest in Tech Stocks?), I believe this area offers excellent opportunities for sensible investors with a time horizon longer than three nanoseconds.

As evidence, consider Legg Mason Value Trust, the only diversified mutual fund to beat the S&P 500 every year over the past nine years (and it's beating the S&P again this year). While its manager, Bill Miller, often buys classic, beaten-down value stocks like Waste Management (NYSE: WMI) and Bank One (NYSE: ONE), he also bought America Online (NYSE: AOL), Dell Computer (Nasdaq: DELL), and Gateway (NYSE: GTW) when they were very cheap a few years ago, and more recently has been buying Amazon.com (Nasdaq: AMZN), now his fifth-largest holding. Miller simply looks for stocks that the market is misunderstanding and undervaluing. That's all value investing is: attempting to buy something for less than it's worth.

There are many reasons why a stock might be undervalued. Common ones include:

  • The stock is too small or illiquid to attract much interest;
  • The stock price has not fully reacted to positive new developments;
  • Valuable assets are hidden in an otherwise unattractive business or in a complicated corporate structure;
  • Spin-offs or other transactions create a wave of selling;
  • The consensus view on a company is overly pessimistic;
  • A good company is in an unpopular industry;
  • Momentum-driven selling.

When you identify a stock in which you think one or more of these factors is at work, that's great news. As Warren Buffett wrote in his 1990 annual letter:

"The most common cause of low prices is pessimism -- sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer.

"None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: 'Most men would rather die than think. Many do.'"

Characteristics of the technology sector
Think about the characteristics of an attractive industry for a value-oriented investor. Ideally, there would be highly profitable, high-return-on-capital, well-managed, rapidly growing companies. But, that's not enough, since the market tends to price such companies very richly. One would also want an industry in which the bulk of investors were prone to frequent massive, irrational, herd-like behavior both in bidding stocks upward and crushing them downward. I think this is a pretty good description of the technology sector today, don't you?

So, just buy beaten-down tech stocks, ride them up, sell, and laugh all the way to the bank. Piece of cake, right? If only it were so easy! There are a number of factors to keep in mind.

Circle of competence
Especially when investing in the complex, rapidly changing technology sector, it's critical to understand -- and stay within -- your circle of competence. As Buffett wrote in his 1996 annual letter: "Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. Note that word 'selected.' You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital."

For most investors, I suspect that the tech sector is neither entirely within nor outside their circle of competence. There's a world of difference between the reasonably straightforward businesses of Apple Computer (Nasdaq: AAPL) or American Power Conversion (Nasdaq: APCC) -- two stocks I owned and wrote about recently -- and, for example, the complexity of the technology underlying Juniper Networks (Nasdaq: JNPR) or Brocade Communications Systems (Nasdaq: BRCD).

I feel like I understand the first two well enough to invest in them if the conditions are right, whereas I don't think I could ever understand the latter two well enough to be comfortable investing in them. That's not to knock them -- that's just my assessment of my own circle of competence.

Sustainable competitive advantage
Don't confuse growth with sustainable competitive advantage! This is the most common mistake I see investors in technology companies make. As Buffett wrote in a brilliant article in Fortune last year: "The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors."

Sustainable competitive advantage is difficult for any company to achieve, but this is especially true in the rapidly changing technology sector. Michael Mauboussin makes a compelling case in The Triumph of Bits that New Economy companies are characterized by higher growth and returns on capital, but shorter competitive advantage periods. That doesn't say anything about whether they will be good investments, but it's critical to be aware of this. (For more, see my column on Sustainable Competitive Advantage and Mauboussin's Competitive Advantage Period "CAP," The Neglected Value Driver. More on Mauboussin below.)

Volatility
The volatility of tech stocks can create great buying opportunities, but only for investors with strong stomachs and iron nerves. If you're going to invest in this sector, be certain that you have these traits. Many people without them piled into this sector in the past few years, thinking the volatility was only in the upward direction, and are now selling in a panic.

Ben Graham, in his classic The Intelligent Investor, said it best: "Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to... the operating results of his companies."

Selling
Speaking of selling wisely, it's important to know when to sell when investing in the technology sector. The same factors that can cause a stock to become significantly undervalued can also cause it to become highly overvalued -- sometimes quite quickly. While I applaud and share a long-term orientation, I think locking in some gains when a stock becomes priced for perfection is generally wise.

Investing in the technology sector is very challenging, but with the right approach, can be very rewarding.

--Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for the Motley Fool and other writings, click here.

Recommended Reading
Michael Mauboussin is at CS First Boston and also teaches Ben Graham's old course at Columbia Business School. He's written the best material I've seen on applying traditional metrics to New Economy companies, which is available for free at www.capatcolumbia.com.