U.S. stocks are higher in early afternoon trading on Wednesday, with the Dow Jones Industrial Average (DJINDICES:^DJI) and the S&P 500 (SNPINDEX:^GSPC) up 0.85% and up 0.99%, respectively, at 12:15 p.m. EST.
This column regularly refers to Musings on Markets, the blog of New York University finance professor Aswath Damodaran -- it's a must-read for serious investors. The combination of exceptional writing clarity and deep insights make it a very valuable resource.
On Monday, Damodaran published the fourth post in a series on the compressed life cycle of technology companies, which addresses the specific challenges this poses for investors.
As you might expect from an academic, he methodically breaks these down by investor taxonomy between growth investor and value investor. Since growth investors are typically more attracted to the technology sector, I will highlight the three challenges Damodaran identifies for that constituency. This is the first:
Growth is not always good: I have long argued against the lazy notion that growth is good and that a company should therefore go for growth, at any cost. While that notion is dangerous at any company, it is particularly so at tech companies, where once the life cycle turns, growth is a value destroyer, not a value adder.
This reminds me of a passage from Berkshire Hathaway's 1992 letter to shareholders, in which Warren Buffett points out that "the two approaches [value and growth investing] are joined at the hip: Growth is always a component in the calculation of [intrinsic] value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive."
Here's the simplest way to think about this: You're the owner of a business that is loss-making with no prospects for achieving profitability. Do you want to ramp up growth, or shutter the business?
Growth may not be sustainable: Growth in the past has never been a great indicator of future growth across companies, but it is a particularly misplaced notion with tech companies, where growth rates can change overnight.
The easiest way to forecast future growth is simply to extrapolate the recent trend; unfortunately, technology companies are particularly susceptible to inflection points at which the trend reverses.
A dramatic example of this is BlackBerry Ltd (NASDAQ: BBRY), which sold the eponymous handheld device. By the end of its fiscal year ended Feb. 26, 2011, the company had just completed a decade during which it grew its revenues by a factor of 90.
Alas, by Feb. 2011, the iPhone had already been released for nearly four years. In its next fiscal year, BlackBerry's revenues fell 7.5%; within four years, revenues had collapsed by more than four-fifths.
PEG Ratios are misleading: If value investors put their trust in P/E ratios, growth investors put their [sic] in PEG ratios, the ratio of P/E to growth rate. A low PEG ratio is considered to be a signal that a company is under-valued; this is dumbed down even more when a PEG ratio below one becomes a magical indicator of cheapness.
Using the tech life cycle rubric, I would argue that the PEG ratio approach will lead to too many tech companies looking cheap during their high growth phase and too few in their decline, the mirror image of the problem faced by value investors ... Note that early in the life cycle, tech companies have lower PEG ratios than non-tech companies and later in the life cycle, they look expensive.
Due to its compressed life cycle, investing in the technology sector is particularly tricky. If you understand the three caveats related to growth that Damodaran identified, that is at least a sound basis for beginning to think about technology investing.
Alex Dumortier, CFA, has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.