Why tech stocks deserve to be cheaper than industrials

By Felix Salmon
July 25, 2011
buysidemetrics for finding this very smart quote from Bill Gates, which actually comes from a discussion he had with Warren Buffett in 1998:

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Many thanks to commenter buysidemetrics for finding this very smart quote from Bill Gates, which actually comes from a discussion he had with Warren Buffett in 1998:

BUFFETT: The technological revolution will change the world in dramatic ways, and quickly. Ironically, however, our approach to dealing with that is just the opposite of Bill’s. I look for businesses in which I think I can predict what they’re going to look like in ten or 15 or 20 years. That means businesses that will look more or less as they do today, except that they’ll be larger and doing more business internationally.

So I focus on an absence of change. When I look at the Internet, for example, I try and figure out how an industry or a company can be hurt or changed by it, and then I avoid it. That doesn’t mean I don’t think there’s a lot of money to be made from that change, I just don’t think I’m the one to make a lot of money out of it.

Take Wrigley’s chewing gum. I don’t think the Internet is going to change how people are going to chew gum. Bill probably does. I don’t think it’s going to change the fact that Coke will be the drink of preference and will gain in per capita consumption around the world; I don’t think it will change whether people shave or how they shave. So we are looking for the very predictable, and you won’t find the very predictable in what Bill does. As a member of society, I applaud what he is doing, but as an investor, I keep a wary eye on it.

GATES: This is an area where I agree strongly with Warren. I think the multiples of technology stocks should be quite a bit lower than the multiples of stocks like Coke and Gillette, because we are subject to complete changes in the rules.

This I think is the heart of the reason why technology stocks are trading at lower multiples than industrials. There’s no doubt that in an era of massive change, there will be a handful of tech companies which are huge winners. On the other hand, there will be some giant tech companies which are big losers, too. (Just see the fate of Apple since 1998, and compare it to the fate of Microsoft.) In general, if the number of losers exceeds the number of winners, or if the winners start out small and the losers start out big, then that’s a sector you’d be smart to buy only at relatively low multiples.

Meanwhile, in an area where change is unlikely to massively disrupt your business, income streams are more predictable and therefore more valuable.

Another way to look at this is to take the simple but powerful heuristic that the expected lifespan of any company is twice its current age. Wrigley’s and Coke and Gillette have been around a lot longer than Microsoft or Apple or Facebook, and there’s a very good chance that they’ll still be here when the current tech stars are distant memories. If I had to buy one asset for the ultra-long term — something on the order of a few hundred years — then I’d probably end up buying a timber forest: those things last forever, with growth that is so steady and predictable that it’s literally a science, and yields which can easily be stored up during periods of market weakness (just by cutting down fewer trees).

So then the next question arises: why are tech companies trading lower than industrials now, when they’ve never done so in the past? Has the market suddenly become uncharacteristically rational?

That’s a harder question to answer, but I think that it’s fundamentally based on the fact that the giants of the dot-com era are still big and entering a long-term decline — think Microsoft, or Intel, or HP, or Yahoo. Meanwhile, the exciting smaller companies, insofar as they exist, simply aren’t public.

And it turns out that even Warren Buffett’s boring and predictable companies like Coca-Cola can benefit from huge and unpredictable trends. Mark Bittman has a good piece in this weekend’s NYT which included this chart:

soda.tiff

I don’t think that anybody — not even Warren Buffett — could have predicted 30 years ago that soda price inflation would so massively lag both consumer prices generally and food prices in particular. Healthy food is now twice as expensive, relative to soda, as it was in the early 80s. Which obviously does wonders for Coca-Cola’s brand franchise, even if it causes billions of dollars a year in damage elsewhere in the economy. If I’m a long-term buy-and-hold investor, that’s the kind of trend I want to jump on. Rather than, say, Farmville. To make money in Zynga stock you need to know when to sell. To make money in Coca-Cola stock, you don’t.

7 comments

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Great post Felix!

Safe dollars are worth more than risky dollars and a dollar today is better than a dollar tomorrow. I love investing in industiral businesses which for whatever reason are trading below net tangible book value. That measure excludes the value of goodwill, brand, and even intellecutal property.

Finding stocks trading at less than that metric are rare and they all tend to be micro-caps or destressed companies. Still though there is such a huge margin of safety that even if the company goes through a liquidation you’re going to get some kind or a recovery.

Having said all that I still think large cap tech is cheap relitive to every other sector except energy right now. It takes a long time for industrial or even consumer companies to get global. Tech is so ubiqutous globally that Apple dosen’t even have to open stores in China… they just open themselves!

Posted by y2kurtus | Report as abusive

Are you really holding MSFT as a loser stock since 1998? They’ve earned > $100B over that period and paid out massive dividends – plus it’s held close to the DOW up 63% vs up 67% for the DOW. Funny to use KO also, as it’s only up 8% over that period – compared to MSFT up 63%.

It is easy to see that the price of name-brand carbonated sodas would increase at a slower rate than fresh fruits and vegetables. Look at the price inputs. The majority of the cost of a can of Coke goes towards marketing and management. How about fresh fruits & veggies – land costs, labor, transport & fertilizer. Sure HFCS can double in price because of corn’s price, but really, how much does that impact Coke’s cost?

What should concern you about Intel is that their engineering philosophy – build it smaller – the driver of Moore’s law, will be necessarily constrained by physics. You can’t build layers less than one molecule thick, and when you get to one molecule, as opposed to say ten or a hundred, things behave much differently. How intel will deal with the inability to simply reduce feature size is a bigger threat to its long-term future than it merely being a tech business. For MSFT, you can take the philosophy that new software will always be needed. Even when new Intel processors slow in their introduction, there is a lot of room to improve the efficiency of MSFT’s products.

Posted by winstongator | Report as abusive

@winstongator: Intel has been dealing with it for the last decade. What miniaturization enabled with increased clockspeeds, which largely drove performance in the 1980s and 1990s. Today it’s multicore processors, which rely much less on miniaturization and more on parallel processing. Of course, this is driving a major shift in software development, which will not be fully complete for at least another decade (and probably much longer).

The problem with Microsoft is that the large bulk of its profits come from Windows and Office upgrades, products that were first conceived and built in the 1980s, and which came to dominance in the early to mid 1990s. It has not shown the ability to use its extensive resources to lead in new markets such as search, phones, and tablets.

Microsoft has the classic big company disease (http://wp.me/pJhAL-6k). It is less risky and more profitable to offer improved versions of existing products than to enter new markets. Desktop computing isn’t going away, and Microsoft will continue to make a lot of money from these products for a long time. They just don’t define computing any more.

Posted by Curmudgeon | Report as abusive

One thing that is not addressed in the comparison between tech stocks and other industrials is the earnings growth rate. A large reason tech stocks have traditionally had higher P/Es is they have had higher growth rates. They often don’t pay dividends, so the only reason they have high P/Es is their earnings are growing much faster than non-tech companies. However, it’s possible that the growth rates of many publicly traded tech stocks have slowed down in the past few years, which would generate lower P/Es. It would be nice to see that graphed alongside the average P/E for tech companies.

Posted by KenG_CA | Report as abusive

Stocks have P/E rates that are forward looking in that they assume the company will be there several years from now still churning out product people want. Ultimately investors need to see returns from stocks in either dividends or the promise of a liquidation or buy-out value of the company much greater in the future than today.

There lies the rub for tech companies. Moore’s Law dictates that the entire industry will be subject to massive change once or twice per decade due to the dramatic increases of computing power and memory storage. A glimmer in somebody’s eye in 2000 may have become commercially feasible in 2004, very cost effective in 2008, and replaced by something else in 2011. There are very few other sectors subject to this massive rapid change.

Why would an investor pay 40x annual earnings for something that pays no dividends, and then simply vanishes without a trace a decade later? Fundamental investing indicates that the 40x implies that it will be of much greater value a decade hence than today.

Posted by ErnieD | Report as abusive

Industry benefits from the hardware and software developed in the tech sector. Most of the gains from improved technology accrue to the users, not the creators.

Posted by DavidMerkel | Report as abusive

Just a minor quibble. The chart tells us nothing about the relative prices of the goods to each other, only to their own price in 1982. The chart doesn’t say that all those goods were the same price in 1982, so we have to assume that the baseline is just whatever their price was. So fruit is 2x more expensive than it was in 1982; Coke, around 50%. But we can’t say fruit is 2x more expensive now than Coke was because we have no idea what it cost then. Fruit today could still be cheaper than Coke today.

Posted by ZacharyST | Report as abusive