Creative Destruction at Play

The technology sector has come a long way since the heady market highs of 2000 and yet many investors still treat it with circumspection, thanks to the bursting of the internet bubble and crazy dot com valuations. We believe that the sector has evolved and that much of what was promised in 2000 is now becoming reality.

Looking back, the 1980‘s was all about the migration to the PC, followed by the rise of the Internet in the 1990‘s and culminating in the NASDAQ bubble of 2000. To illustrate how far the industry has come, I thought this quote from Computerworld magazine summed it up rather nicely: “If the auto industry had done what the computer industry has done in the last 30 years, a Rolls-Royce would cost $2.50 and get 2,000,000 miles to the gallon.”

It is our view that we are at the forefront of the third wave of a disruptive new cycle – namely that of connected computing. This has been made possible thanks to three key drivers – cloud computing, broadband applications and the growing ubiquity and mobility of computing. The glue that keeps all of this together is the affordability and speed of broadband. To illustrate this point, NTT Japan has successfully tested fibre optic cable that pushes 14 trillion bits per second down a single strand of fibre, which in plain language is equivalent to 2660 CDS or 210 million phone calls every second!

Ironically, it was the cheap capital of 2000 that allowed broadband to become so pervasive, as companies had so much money thrown at them that it allowed telecom operators to create broadband virtually for free.

To digress for a moment for those of you who are not tech savvy, I‘ll explain what cloud computing is all about. It means that instead of all the computer hardware and software you’re using sitting on your desktop, or somewhere inside your company’s network, it’s provided for you as a service by another company and accessed over the Internet, usually in a completely seamless way. Exactly where the hardware and software is located and how it all works doesn’t matter to you, the user – it’s just somewhere up in the nebulous “cloud” that the Internet represents. This is exciting because it allows companies to make savings and to boost efficiency. It also allows smaller companies to become more competitive, without being forced to spend a huge amount of capital on IT infrastructure. Furthermore, it’s changing the way the world works as your competitors aren’t just in the next town or the next country, they could be eight time-zones away and you probably have never heard of them.

As the third wave plays out there are going to be winners and losers in technology, as new entrants take over from the old stalwarts. Driving the change is the rise of the mobile internet device or smart phone / tablet. Previously the preserve of early adopters and enterprise, 2010 was the year when smart phones became mass market products as volumes grew 80% year over year. Penetration rose from 18% to 27% by the first quarter of 2011. The key winner in this space has been Apple, now the largest market capitalisation stock in the world.

This is unleashing wide ranging forces across the capital equipment, software, hardware, telecoms and consumer electronics sectors. The potential losers in this revolution are easily identified. They are the technologies and companies that shaped the PC era over three decades: Intel and Microsoft, other PC makers as well as hard drive vendors and original design manufacturers that produce over 80% of PC notebook components.

Take Microsoft, for example. With a price/earnings ratio of around 10 the software giant is a value play for some hedge fund managers, including Greenlight Capital‘s David Einhorn. Even Warren Buffet has recently called Microsoft – cheap. But the likes of Ben Rogoff of Polar Capital believe that Microsoft and most other stocks in the PC camp will provide disappointing returns to investors. GLG’S Technology Fund team says, “To discuss one year’s P/E is flawed. It is not that valuation is unimportant. It is instead important to look at an addressable market and how it will evolve over four or five years. Apple and ARM, and others, are slowly destroying the business models of Intel even though they are still making decent profits.”

However, the GLG team doesn’t expect the losers to blow up as connected computing continues to evolve and grow. Instead, their sense is that the stocks of earlier tech eras will behave like IBM, which in the 1990s fell slowly but relentlessly until the company had lost 80% of its market value. We are not arguing that Microsoft or Intel will disappear. What we are saying is that they will be affected for maybe 10 years or more as the market they address gets smaller and they operate at lower (profit) margins.

Companies which we believe are on the cutting edge of innovations have to be the likes of Apple. Thanks to the popularity of the iPhone, Apple has managed to capture over 17% of the global smart phone market in less than 36 months. Apple’s cash reserves exceed $34 billion, enough to buy the world’s leading PC vendor, Dell, and still leave change. It also has more cash on its balance sheet than the entire market capitalisation of Nokia. Apple’s flagship store in Regent Street is the most profitable for its size in London, earning twice as much per square foot as Harrods. Apple is not alone in having lots of cash on its balance sheet and this cash, which is burning a hole in many legacy companies’ pockets, should be supportive of the small and mid cap technology shares today.

Developments in the technology space are changing so quickly that one needs the steady hand of fund managers who really understand the space. For every 60-fold gainer like Autonomy there are equally spectacular examples of capital destruction. Nortel Networks, worth $250 billion in 2000, crashed from $83 per share to under $1 in just two years! It is important to learn from history and the lessons show that the winners typically win for longer than people think while the losers always look cheap and present dangerous value traps.

To end off, it would be remiss of us not to comment on the rise of Social media aka Facebook, Twitter and the like. Some info:

% With over 500 million users, Facebook is now used by 1 in every 13 people on earth, with over 250 million of them (over 50%) logging in every day.

% To reach 50 million users took Radio 38 years, TV 13 years, Internet 4 years and Facebook 9 months.

% 48% of 18-34 year olds check Facebook when they wake up, with 28% doing so before even getting out of bed.

% Almost 72% of all US internet users are now on Facebook, while 70% of the entire user base is located outside of the US.

% Over 700 billion minutes a month are spent on Facebook, 20 million applications are installed per day and over 250 million people interact with Facebook from outside the official website on a monthly basis, across 2 million websites.

% Over 200 million people access Facebook via their mobile phones.

% 1 in 8 people married in the US last year met via social media.

% Social media has now overtaken pornography as the number one activity on the web.

% 48% of young people said they now get their news through Facebook.

% 14% of people believe adverts, 78% of people believe peer reviews.

% If Facebook was a country it would be the world’s fourth largest.

We are not alone in being nervous of their valuations and to date none of the funds that we invest in hold these companies, largely due to the fact that the real winners have not yet listed! When they do list, their valuations are bound to be on the high side and many will talk about bubble valuations, but as the following example shows, social media companies march to a different drum. The traditional methodologies of one year forward P/Es for companies that show exponential growth are not necessarily appropriate.