Investment Climate April 2012

We recently sent out our quarterly "Investment Climate" to our clients, in which we make a few comments about our current view of issues of importance to investors.

Our performance data through the end of the March 2012 quarter has also been updated and can be found in the "Investment Management" portion of our Taylor Frigon company website here.

Mobile computing and growth investing

We recently attended the 2012 Linley Mobile Technology Conference, which was held in San Jose on April 16 and 17 and hosted by technology research firm The Linley Group.  The conference was attended by numerous engineers for companies involved in the design of mobile connected devices and the components that make those devices do what they do.

The most dominant theme that emerged from the various presentations and discussions is the enormous pressure that the insatiable consumer demand for the rapidly-evolving mobile user experience places on the engineers and architects who must make it happen -- and the creative and innovative ways that those engineers and architects are meeting the challenge.

Stop and reflect on the amazing changes that "mobile connected devices" have been undergoing over the past several years: not too long ago, the only mobile devices of note which were connected to any kind of networks were mobile phones and mobile GPS devices, but now mobile connected devices (primarily smartphones and tablets) have become the mobile equivalent of desktop computers and "home entertainment centers," complete with the ability to act as mobile phones and GPS devices whenever necessary.  

We now expect to be able to consume more and more video and other demanding applications while mobile, with higher and higher resolution, we expect our device to always be able to get a signal and never drop it or even have delays in the stream, and we expect it to be able to give us all this increasingly difficult processing of data without running out of power during a long day of constant use. 

In order to keep up with these demands, and create devices that provide users with smoother scrolling, faster browsing, more graphically-intensive mobile gaming, better sound quality on calls, all-day music streaming, and the ability to interface using touch and gesture and even shaking and tilting (and many other functions that we now take for granted), engineers are designing ever-more powerful processors, which will use less and less battery power.  

One strategy for increasing processing power is the use of multi-core processors, which contain multiple cores to process program instructions in parallel inside a chip, which can result in faster rendering of graphics.  In desktop applications, where power was traditionally not as much of a factor as it is in a mobile device, multi-core processors have been around for some time, but while multi-core may provide significant performance improvements, it has some drawbacks (programming in parallel is much different from writing code to control sequential processing, for one thing) and while it is an important tool for chip and system-on-chip designers, simply throwing more cores at the problem is not always the answer.  More important is the ability to turn cores on and off rapidly, to reduce power usage, and even more important are strategic decisions (such as whether it is better to split a task into many smaller tasks, each of which takes less energy to complete, or whether it is better to split a task into fewer sub-tasks and devote a lot of power to solving them quickly, in order to shut down more rapidly and perhaps conserve power that way).

Another important trend is the use of heterogeneous chip design -- the employment of different types of processors to take advantage of the most efficient type of processor for each of the many different tasks these devices must handle.  Some of these different "types" of processors, in addition to the familiar CPU (which traditionally has performed the lion's share of the processing in computers), include GPUs (graphics processing units) and DSPs (digital signal processors), each of which have their own inherent strengths and weaknesses.  By off-loading some of the processing that was once performed by CPUs (processing audio and video with dedicated DSPs, for example), performance can be greatly increased and power greatly reduced.

One takeaway for investors, in our view, is the absolutely revolutionary nature of the mobile technology changes that have been only just beginning to transform our lives over the past several years and which will almost certainly become even more transformative in the years ahead.  For whatever reason, these changes can creep into our lives without our realizing how much they have turned the world upside down (perhaps it is some version of the "how to boil a frog" anecdote), until we stop and think back to what the world was like before.  For instance, the very first iPhone was only released in 2007, but for many it is difficult to even remember what phones -- even cutting-edge phones -- were like before then.

As investors, we need to consider carefully what new fields of growth are created by major shifts of this nature, and position ourselves to participate in the success of companies that are making them happen, or that stand to benefit from the change.  This particular mobile paradigm shift is one that we have been publicly discussing on the pages of this blog since the beginning of 2009 (see this previous post and this previous post among many others), and one that we have been researching and analyzing for a lot longer than that.  If you read through those previous posts, you will find that they are remarkably predictive of the types of trends that are shaping the industry right now.  However, this paradigm shift was largely missed by many "traditional Wall Street firms" over the past several years, and many do not fully understand it even today.

This is one reason why we believe that attending conferences such as the outstanding Linley conferences (which are more well-attended by Silicon Valley engineers than by Wall Street analysts or even members of the press) is so important.  Even more important is to understand the "classic growth" tenets that we believe are the foundation of successful investing (not just "tech" investing), which was discussed in our very first blog post. While the words we quoted in that post were written down all the way back in 1972, those principles really stretch back to the 1930s -- long before the cutting-edge technologies which drive the smartphones and tablets of today were even imagined.

Apple, Amazon, the Sherman Act, and freedom

Memo to Tim Cook: we've finally found a good use for a portion of Apple's enormous hoard of cash -- take the recent civil antitrust case against your company all the way to the Supreme Court.*

Yesterday, in a press conference, Attorney General Eric Holder explained the lawsuit that his Department of Justice is bringing against Apple and five large book publishers. Three of these publishers have already settled with the DOJ, while Apple and two others so far have not.

The details of the DOJ lawsuit can be found in this 36-page complaint, and it makes for fascinating reading. We would urge all investors who are interested in understanding more about the tremendous disruption and power shifts that the ongoing digital and mobile revolution is making in many industries (including the book industry) read the entire thing.

In this case, the DOJ asserts that the publishers banded together to resist the pricing pressures unleashed by the 2007 introduction of the first Amazon Kindle device, which propelled the e-book from a novelty to a real source of potential sales.* The publishers were delighted at the increased sales channel, but frustrated with Amazon's policy of dictating a price of $9.99 or lower for e-books sold through Amazon. They were also frightened at the possibility that such a price would create an expectation among consumers that e-books should never be priced higher than $10, and that this new consumer expectation would erode the value that consumers saw in physical books as well (in other words, erode the price that physical books, including new hardbound bestsellers, could command).

According to the DOJ, the five publishers colluded with Apple in 2009, which was at the time preparing for its launch of the first iPad in April 2010 -- a device that the publishers realized could give them a market for e-books other than Amazon and enable them to have some power to bargain against Amazon's stubborn refusal to sell e-books at prices above $9.99. According to the lawsuit, the publishers along with Apple signed an agreement with one another in January 2010, and not long after that they challenged Amazon with the ultimatum: let us price our e-book releases. When the publisher sets the sale price it is know as an agency model rather than a wholesale model wherein the retailer purchases the book or e-book at a wholesale price and then sells it for whatever price they want.

Because the five publishers collectively represented nearly 50% of Amazon's e-book sales, the DOJ complaint reports that Amazon caved within two days and allowed the publishers to have an agency model and to sell the e-book version of bestsellers for prices above $9.99.

The remarks by Attorney General Holder call this an affront to Amazon's "freedom to reduce the prices of their e-book titles" and the DOJ complaint alleges that the actions and agreements of the publishers and Apple violate the Sherman Act, which was passed in 1890 in order "To protect the consumers by preventing arrangements designed, or which tend, to advance the cost of goods to the consumer."

It would certainly seem that the actions of the publishers and Apple made some "arrangements designed, or which tend, to advance the cost of goods to the consumer" -- after all, their arrangements broke the $9.99 price cap and enabled publishers to sell e-books priced at $12.99, $14.99, and even $16.99 or more in some cases.

But let's step back and ask why the United States Department of Justice should be jumping into the fray to force publishers to sell books through Amazon at $9.99. If you were an author of a highly-anticipated book, one that was already on the bestseller lists or was certain to jump onto the bestseller list the moment it was released, and you felt that you would be able to sell just as many e-books at $19.99 as you could sell at $9.99, why should the government tell you that you must give away that additional $10 per book? After all, nobody is holding a gun to anyone's head and forcing them to buy the books -- it's their own money, and presumably if they are willing to pay $19.99 for an e-book of your new bestseller, that means that the new bestseller is worth $19.99 to them.

Of course, defenders of this action might argue that no one is forcing the author (or her publisher) to sell the e-book through Amazon either, but that is not entirely true, is it? In a free environment, the author (or her publisher) could say to Amazon, "OK, if you won't let us sell this e-book for $19.99 (and it's worth at least that much), then we will just take our ball and go home. We will set up our own website and sell the e-book there, or sell it to users of the Apple iPad, and instead of getting a piece of the sales, you will not see any of it." That's what the publisher could say, and that's exactly what the DOJ complaint alleges that the publishers did say, and now the DOJ is filing a lawsuit against them because of it.

Note that in the business world, if you realize that the person you are bargaining with cannot walk away, you have no reason to accede to any of their demands. In this case, the DOJ is saying that the publishers cannot bargain with Amazon, or at least that if they bargain with Amazon, they cannot threaten to take their ball and go home, because if they do that, DOJ will stop them.

While we like inexpensive e-books as much as the next person, we wonder where exactly the DOJ found a Constitutional right for all consumers to buy e-books for $9.99 or less (no matter how new or how popular, and no matter how much the author or her publisher wants to charge for them).

Some might argue that it's OK for one author or one publisher to try to bargain with Amazon, but that the problem arose when the publishers got together to increase their bargaining power over Amazon (the DOJ also seems upset that the CEOs of the publishing companies met in "upscale Manhattan restaurants," as if all CEOs should hold their meetings at fast-food restaurants and that those who do not are insidious). However, we would again ask why trying to increase one's bargaining power should be against the law -- it is actually a very common practice to increase scale and get a better deal. Should farmers' co-operatives be busted up by the DOJ? Should online coupon companies that offer consumers a better price for something as long as a certain number of them all show up to buy the product be illegal?

Also, while it's nice that the DOJ is so concerned for the readers of e-books, it seems quite unfair that they don't seem to be concerned at all for the authors. Eric Holder's statement describes the retailers' "freedom to reduce the prices of their e-book titles," but doesn't seem to care about the authors' "freedom to have any say in the prices of their e-book titles." Isn't it true that if e-book titles are priced too high, that consumers will buy less of them, or stop buying them at all?

We are on record as being huge supporters of innovation, and the value-adding (and price-reducing) power of new technology, including Amazon's Kindle and the e-book. We are, in fact, shareholders of Amazon as well as Apple (as disclosed below). However, we believe that this is a fight that should be allowed to work itself out without the interference of the federal government.

If the DOJ wants to maintain this line, Apple should take it all the way to the Supreme Court. It is an important issue of personal freedom.



* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL) and Amazon (AMZN). They do not own securities issued by any other company mentioned in this post.

Innovation, innovation, innovation

Here's a terrific new video from economist Brian Wesbury entitled "Good Thursday, Good Friday," explaining that the economic recovery is now building on itself in a virtuous cycle.

Mr. Wesbury points to three reasons for the fact that some important economic measures are better right now than they have been since 1999, and the first (and, in our view, most important of these) of these involves innovation.

He called this first reason "technology," but he doesn't simply mean companies that Wall Street thinks of as the "technology sector," because he then gave examples which include hydraulic fracturing (aka "fracking"), which certainly involves technology but not "Silicon Valley-style" technology, so we think a better word for what he is talking about would be "innovation."

The United States of America has traditionally been a world leader in innovation, often combining existing things in new and unexpected ways -- think of the skateboard for example (originally a combination of the concept of the surfboard and roller skates), or the more recent snowboard (an application of the concept of the surfboard to snow skiing, to create an entirely different approach to downhill skiing). Hydraulic fracturing, which we have discussed in previous posts such as this one, is yet another example of this type of innovative combination, and one that is changing the world as much as skateboarding and snowboarding did in their own ways.

The reason innovation is so important is that it is the only thing that really grows the economy. The other two reasons Mr. Wesbury lists -- an accommodative Federal Reserve and a government and regulatory environment that appears to be slowly getting out of the way, relatively speaking -- cannot grow the economy. They either obstruct innovation, or (in a perfect world) they don't, but they do not innovate and therefore they do not create growth.

As Mr. Wesbury points out, the current state of Fed policy and regulatory policy are not entirely "good," but he sees signs that they are obstructing growth less than they perhaps could be.

The important lesson is that innovation is what drives the economy, and what we need to focus on as investors. Monetary policy from the Fed or stimulus bills from the Congress do not really grow the economy.

However, as we have pointed out in previous posts and as Mr. Wesbury points out in the video today, innovation remains alive and well in the US (and in other economies as well, sometimes to a greater or lesser degree depending on their own situation with the other two factors).

Thus, we would argue that there are really only three things matter the most for an economy and for future growth: innovation, innovation, and innovation.