What battles of the tech titans tell us about investment theory

The news recently provides some valuable data points which we believe confirm the arguments we have been making on these posts for the past two years concerning the "unstoppable wave" (see for instance here, here, and here).

First, Dell and HP got into a ferocious bidding war over utility storage provider 3PAR, and now Oracle has announced it will bring on former Hewlett-Packard CEO Mark Hurd as co-president to further Oracle's strategy of providing clients with more integration of software and hardware. ZDnet's Larry Dignan has some notable insights on that move in an article here.*

While these recent headline-grabbing maneuvers by the largest of the tech titans are notable for investors, and notable for their confirmation of the tectonic shifts we have been describing as important for investors to understand, we believe that it also provides an opportunity to make a larger point about investment philosophy.

We have always argued that investors should view investing as the allocation of capital to well-run businesses positioned in front of above-average growth opportunities. When we highlight major paradigm shifts such as the one described in the blog posts linked in the first paragraph, above, we do so in the context of pointing out that investors should be considering well-run companies that may be providing goods or services related to such opportunities.

While that may sound like common sense, there is actually a school of thought which argues that attempting to identify exceptional companies is just a gigantic waste of time. In fact, the proponents of this theory usually argue that it is worse than a waste of time -- it is a waste of money and a dead-end for investors. Some of them even argue that it is "anti-free market" and a form of denial that "markets work"!

We believe that the recent battle of the tech titans should help illustrate some vital points. HP and Dell got into a vicious bidding war over 3Par and drove its selling price to over $2 billion, upping Dell's initial bid of $18 a share all the way to $33 per share -- over 83%. Keep in mind that the 83% bidding escalation came on top of the initial Dell bid of $18, which was in itself about an 80% premium to the $10 price range in which the 3Par stock was moving before the initial offer.

Businesses don't throw money like that around just for the fun of it -- the tectonic shifts we have been pointing to in this blog are happening, and there are going to be winners and losers when these shifts take place. Companies both large and small are jockeying for survival. When the landscape is changing rapidly, companies that once absolutely dominated their respective kingdoms can find themselves toppled and overthrown. Those who have followed the changes in the computer world long enough will perhaps remember what happened to former heavyweights DEC, Wang, and Burroughs.

For a deeper understanding of these shifts, we would recommend George Gilder's important and far-sighted 1996 article in Wired magazine which we have discussed before, as well as the concepts articulated by thinkers such as Joseph Schumpeter.

The investment lesson we believe should be taken from this subject is quite different from the lesson that many mistakenly draw when they think about these matters. Often, we hear people argue along these lines: "that's why investors should buy all of those companies -- you just don't know who will win and who will lose -- I recommend a good tech sector fund, or ETF, or maybe just a broad index fund, for that very reason!"

Unfortunately, that argument is flawed, especially if you are talking about the larger-cap companies, which are the only ones with which most commentators in the financial media (and many representatives of the financial industry) are familiar.

We believe it is much wiser to search out and carefully research several smaller companies which are innovative, well-run, and positioned to take advantage of the new paradigm. If an investor buys five such companies and four of them don't pan out but one of them returns ten-fold, it can make up for the others.

On the other hand, if an investor buys five mature titans in a rapidly-changing industry, and three or four of them languish, dying a slow death over many years, the one or two winners will probably have little chance of growing five-fold or ten-fold. The most an investor can generally hope for in a giant mature company, even if it is a winner, is a double (there are, of course, exceptions). With such odds, it should be clear that the strategy many people advocate does not have much promise for the investor. We have articulated other problems with the "buy the entire sector" and the ETF approach in other previous posts as well (see for example here and here).

As an aside, in our first example we posit selecting five smaller companies and having only one succeed. It is our conviction that with reasonable research that looks at the right business criteria, it is possible to pick the winners and the losers -- not with perfect accuracy, but perhaps at a rate that is better than merely one in five.

We believe this is a very important principle, and one that doesn't just apply to the tech sector, but to all businesses in a free economy (remember that when Schumpeter was writing, he used illustrations from farming, with innovations such as crop rotations and tractors -- after all, he was born in 1883).

It should reinforce what we hope is the constant message of our blog -- that investors should think of investment as the allocation of their capital to businesses, and that they should spend most of their investment energies looking for good businesses positioned to add value in an ever-changing landscape that will necessarily have winners and losers.

* At the time of publication, the principals of Taylor Frigon Capital Management do not own securities issued by any of the companies mentioned above, including Dell (DELL), Hewlett-Packard (HPQ), 3Par (PAR), or Oracle (ORCL).

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For later posts dealing with this same subject, see also: