My basic theory on tech investing

Investing in technology is about product cycles. This holds for both outside investors as well as company decision makers weighing product investments. If a company has the right product at the right time it succeeds, and the stock does well. If the company misses that product cycle its results suffer. If it misses several cycles or a major secular shift, then the company fades to irrelevancy – bankruptcy, discounted acquisition or the worst fate of all – permanent zombie status.

Of course, there are several parts of ‘having the right product’. The company has to have a working product, it has to be competitive with other offerings, and they have to be able to deliver the product. There is also an important element of timing here. Being too early or too late is the same as not having the product at all. “Technology” is still generally a growth industry, and for a variety of reasons, technology moves very quickly. This subject is always assumed to be a given. We talk of things moving in “Internet time” and we are all accustomed to Moore’s Law driving a constant obsolescence of products. (We take it for granted, but in some future post, I will explore the underlying reasons for it.) I think it is more complex than “Moore’s Law”, but for the purposes of the discussion here it is important to remember that the industry does move quickly.

Finally, it is important to remember customers in all this. As I will explore in a later post, all too often the needs of the customer get forgotten in the rush to build ‘the right product.’ I have found that my role in many meetings is to ask the question “what problem are we solving for the customer?”, because no one else is asking. Keeping up with product cycles means having the product that customers need, or at least want. This is were the concept of the ‘good enough’ product often comes into play.

Tech Stock Picking

I built this theory painstakingly as an analyst. And by painstaking, I mean getting it wrong often. Now, I am fairly convinced that 80% of tech stock picking is about understanding this product cycle. Another 10% is gauging whether management can repeat the success or if they just got lucky this one time. The other 10% is valuation.

Let me give an example. In 2003 Motorola investors had pinned their hopes on the U650. At the time, it was a highly advanced phone, which in 2003 meant a color screen flip phone for Verizon. Unfortunately, the phone missed its October launch window, and then was delayed again in November. This meant the company missed the 2003 Holiday shopping season. The stock took a beating when they missed Q4 numbers, and then remained out of favor for almost a year. The Verizon shelf space went to LG and Samsung, who had already been steadily gaining share in the US.  Fortunately for Motorola, they launched the RAZR six months later. It may be hard to remember that far back in cell phone terms, but the RAZR was a major hit that set the bar in phone design until 2007 and the iPhone launch. In the end Motorola missed one cycle than hit the next one nicely. For investors who spent the time on the floors of Verizon stores in late 2003, the short side of that trade would have been clear. The long side of that trade with the RAZR was hard to pick up beforehand, but once launched it drove the stock for a considerable period.

There are many other examples, and of course the mother of all product cycle shifts was the transition to smartphones. But my point is that the small product cycles are important.

I would argue that this holds true as much for software as it does for hardware. With most software now basically operated on a cloud-hosted service model, product cycles are less punishing since there is always the possibility of an update or 1.1 version of a release. Nonetheless, timing cycles still matter. For instance, one VC told me recently, that as much as developers talk about Agile software development and constant updating, it turns out the launch a mobile app looks a lot more like a traditional ‘waterfall’ engineering product than the nimble ‘Agile’ developments many aspire to. Apps typically see 80%-90% of their downloads within a month of launch. Having a buggy product on the App Store often results in an app getting relegated to the dustbin permanently. So for apps, the product cycle can be measured in weeks.

A lot of investors tend to lump all “Tech” stocks together, and I think this generally makes sense. However, there are some big differences within the sector around the timing of product cycles. Consumer tech cycles are now punishingly short, as little as three months for some lines of phones. Products for the enterprise market tend to be much longer. In both cases, the rules about product cycles hold true, but for enterprise products there is a larger window for companies to hit.

Nonetheless, enterprise customers only have so much attention span, rendering them ill disposed to constant patches and bug fixes. Enterprise software developers still need to make sure their product is ready at the same time customers are making buying decisions. Hardware makers often face a similar dynamic.

In addition to these short term cycles, there are also longer term secular shifts. Since the ‘sudden’ arrival of smartphones, these secular shifts have gotten a lot of attention from analysts and the blogsphere. But this is hindsight talking. No one really predicted the smartphone boom, and today I think very few analysts fully grasp what a secular shift looks like. My reading of the blogsphere lately gives me the sense that everyone is now hyper-alert in their search for the next secular shift – “Bots”, IoT, AI etc. These may be big secular shifts, but the business model behind many of these concepts are still murky.

My sense is that the big shifts will happen in due time, and in the interim the rest of us have day-to-day jobs to do, and that means paying close attention to short term product cycles.

Investing Guide

To boil it all down, I think of this as a three step analytical process.

  1. Understand the market – this is the most straightforward. Know the size of the market, this will never be a precise figure, but understand the rough numbers. This will serve as an important sanity check. No product can be bigger than its end market. Know the customers. What are they buying and why are they buying. Finally, understand the competition. There are plenty of online resources for learning about a market, but there is no substitute for going out and talking to people in the market, both buyers and sellers.
  2. Map the cycle – Has everyone just upgraded? Are there new features coming to play? Of course there are, but understanding how important these are makes all the difference. Are there key purchasing windows? Holidays for consumers and year-end budget flush for enterprises? Has a dominant competitor just launched a great new product? This is a two-sided process. Understand the latest products on offer, but also make sure to understand how customers feel about the stage in the cycle.
  3. Be honest about a company’s ability to deliver the right product – This is the hardest part. especially for companies making product decisions. Outside investors can talk to management and judge their track record. Certain companies with whom I have competed in the past, have a terrible track record of delivering products on time. Other companies are known as execution machines. Often, delivering a good enough product on time is better than having the best product on the market.

Conclusion

I think one of the big differences between “Tech” companies and other industries is the importance of these product cycles. I recently had drinks with a friend in the re-insurance business. There are no product cycles there – just an unending sludge for market share amidst a declining industry. I can think of a lot of other industries that are in a similar state. This holds for many consumer goods companies like autos and food and beverage. These companies regularly refresh product lines or launch new brands, but much of that boils down to marketing and segmentation in the struggle to eke out shelf space and market share. By contrast, technology companies risk complete oblivion if they miss their product cycles. That is the thrill and fear of investing in technology.

 

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