Should We Invest in Technology?

Monday, Rich McCaffery said chipmaker Intel (Nasdaq: INTC) has become a tougher company to understand. He was referring to the company's growth initiatives beyond microprocessors that have made evaluating Intel's future difficult. While arguing it should remain in the Rule Maker Portfolio, Rich concluded he wouldn't be willing to pay as high a price for the company than in the past due to this uncertainty.

I agree with Rich, but his comments shouldn't come as a huge surprise to the regular readers of this column. You might remember that when we sold JDS Uniphase (Nasdaq: JDSU), we conceded we overpaid for a company that we didn't understand very well. The overwhelming theme here is we shouldn't be buying companies unless we have foresight as to what their relevance will be five to 10 years out.

This has become a more difficult process over the years. There was a time when investing dealt mostly with crunching numbers. You began by assessing a company's historical performance, and then developed a set of expectations based on market share gains, sales growth, margin expansion, and the necessary investments the company would need to make to grow its business.

The difficulty of this process was compounded by the fact that information wasn't very accessible, particularly to individual investors. To get corporate filings, such as annual and quarterly reports, you had to send away for them. If you wanted information about new securities, you had to contact the underwriter or the SEC to get a copy of the prospectus.

In today's technology economy, investors play a much different game, one that includes assessing the value of companies' products and services, which in many cases are brand new. This process includes more than just determining whether a particular product will work, but also whether it will do what the company promises, and if it can, if the company's current market value will accurately reflect that.

What will it take to invest in technology? There's a huge difference between understanding the relevance of a particular technology today and what its significance will be in five years. Unless an investor is on the front lines -- selling or designing software, for example -- it's nearly impossible to know with certainty what the next hot product in that industry will be. This is what makes investing in Rule Maker technology companies difficult.

In other words, the process is difficult because technology is always changing. Like Warren Buffett, we look for Rule Maker companies that can generate tremendous amounts of recurring cash flow with very little additional investment, while sustaining lasting competitive advantages. It's difficult to find technology companies that have these characteristics because the competitive advantage periods are relatively short, resulting in tech companies that must reinvent themselves regularly.

With even the best technology companies, it's difficult to know if any have a sustainable advantage over the competition and potential innovation. Innovation occurs when a solution to a problem is found, and I believe it is the most important characteristic of technology. Solutions can range from a new drug to faster microprocessor speed. But because the market demands better solutions to problems -- and rivals will often provide them -- a technology company is forced to constantly refine its products.

Last month, Todd Lebor's article on Intel's management touched on this very subject. Like Rich, Todd concedes that Intel's new business direction is tough to understand, which makes gauging its future results even more difficult. But Todd finds solace because the chipmaker's management is top-notch. With Intel's depth of management, I agree it's tough to argue Intel won't be leading the next generation of chips that extend beyond the communications industry.

To gain foresight into the relevance of a particular company's products, perhaps investors should look first for high-quality management. I've long believed great management with unquestionable integrity and a track record of excellence is our most important Rule Maker commandment. The problem is that it's probably the most difficult criterion to determine and formulate into a methodology.

I'm not suggesting we sell every technology company in the Rule Maker Portfolio, but I am saying we should spend more time examining non-technology companies that are easier to assess and that better match our expertise and knowledge as individual investors. If the managers of this portfolio had some sort of in-depth knowledge of a particular technology industry, such as software, I'd feel differently.

Furthermore, this is by no means a recommendation to go out and buy grocery stores and automakers because we know where their industries will be in five years. We need to develop some way of evaluating technology companies and their relevance in the world. Management is a good start, but it's by no means the complete answer. I welcome all of your thoughts on the Rule Maker discussion board: What does it take to invest in Rule Maker technology companies? 

Mike Trigg doesn't own any of the companies mentioned in this column. His other holdings can be viewed in his personal profile. The Motley Fool is investors writing for investors.