Finally, The End of Zero Interest Rates!

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We previously wrote a short post asking "Does the Fed have the guts to do it?".

Well, today the Fed did raise rates, after keeping their target at essentially zero for seven years.

Economist Brian Wesbury, whose interpretation of economic events has been cited many times on the pages of this blog through the years, provides some worthwhile discussion of today's Fed decision here.

He notes that, although many commentators are describing the Fed statement that accompanied the decision as "dovish" in nature, the points made in the Fed statement are actually "mildly hawkish," including the comments regarding employment and "utilization" data, and the statement that -- even with this small rate hike -- monetary policy remains "accommodative."

Brian Wesbury concludes by saying that:
Today's rate hike isn't going to hurt the economy; it will help the economy by signaling the eventual end to a policy that has distorted economic decisions for the past several years.
We agree. 

Read the entire article by economist Brian Wesbury, as well as the entire statement from the Federal Open Market Committee, here.
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Hissy Fit, Part 2; Does The Fed Have The Guts To Do It?

We wrote about the concept of the market throwing a "hissy fit" back in the summer over the prospects of the U.S. Federal Reserve Open Market Committee's (FOMC) decision to raise the target for the Fed Funds Rate.  

At the time it was expected that the Fed would hike the target rate in September but the weakness in the market (translated at the Fed to potential weakness in the economy) clearly spooked the Fed enough to keep them on hold.  As such, the expected September rate hike never happened.

Next week, December 15th and 16th, the FOMC will meet again to determine the Fed's target for short term interest rates.  It is now widely believed that they will vote to raise the target from 0% to .25%.  

Hardly a massive move up, but once again, the market seems to be throwing another hissy fit and, frankly, it is just not all that surprising.  There is a prevailing view in financial circles that the market has only been propped up in recent years by a very loose Fed policy on interest rates and that "taking the punch bowl away" will send the economy, and thereby the market, into a tailspin.  Clearly, market forces are testing the Fed in this moment of decision.  What will the Fed do?

Well, the Fed may have backed themselves into a corner by waiting so long to end the "zero interest rate policy" (ZIRP), and we have discussed this before.  But since looking backwards is never a fruitful endeavor, we certainly hope they will get on with the task of normalizing monetary policy and allow the world to move on from the "crisis" footing that it has been on for seven years now.  

Does the Fed have the guts to make this change in policy?  We shall see.  But we would not be surprised to see a rally in markets on the announcement of an increase in the rate target. How far and how fast the Fed ultimately goes will then become the point of focus for the markets, but getting on with the task is a major step, and one that is long overdue.
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Naysayers and Interest Rates

We've discussed our views on the economy and what effect we think higher interest rates will have on it many times over the last 6+ years since the bottom of the "crisis"-driven stock market in 2009.

It would appear that the Federal Reserve is finally ready to end the "zero interest rate policy" (ZIRP) that it has pursued for half a decade now.  This morning on CNBC pundit Jim Cramer stated that only people who are "too young or are foolish" think that higher interest rates are good for the stock market.  After over three decades in the professional investment management business, we are pretty sure we are not the former; and we think disagreeing with Mr. Cramer does not suggest one is foolish.

We've said for some time that the market may well throw another of its "hissy fits" when the Fed begins raising the target for short term interest rates; however, we believe that a return to normalcy (assuming 0% interest rates are not, nor ever have been, normal) will move the economy and, more importantly, the psyche of market participants in a more positive direction, thereby leading to stronger markets in the future.  And furthermore, maintaining ZIRP creates distortions in how capital is allocated and causes unintended economic consequences which are very hard to predict and create more uncertainty.

Just in case our readers should assume that we are "out on a limb" in our views on this topic, we would note such notable figures as Stanford Economics Professor John B. Taylor, former Western Asset Mangement Chief Economist, Scott Grannis, and Chief Economist at First Trust, Brian Wesbury, have all stated support for raising rates.

Stay tuned, as we still don't know for sure if the Fed will act to finally raise rates before the year is over, but we definitely believe such action is long overdue and will ultimately get us pointed in the direction of normalcy.
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Investment Climate: Get out of the "Market"??

The Fed didn’t raise rates and the market still had a fit.  Many continue to say the next crisis is upon us, as they have for years now.  Europe is a mess.  China is collapsing.  The Middle East is a bigger mess.  Politics is…well POLITICS!  And, about the market?  Get out!

Our longest term clients, those who have been with us since the beginning 30 years ago (we still have our first client), have just been floored by that statement!  They’ve never heard us utter such words.  They are thinking we’ve either lost our minds or spent too much time in the beautiful California Central Coast sun and it has baked our brains.  But we really think this call is long overdue.  If you have bought into the market, then we do feel it is high time you get out.  Instead, invest in businesses.

Okay, now our clients are starting to feel a little better.  It’s the old Taylor Frigon mantra about to hit you square in the eyes. 

But it is true that we believe it is time to get out of the market, if it’s the market in which you think you are “investing”.  We’ve all heard, ad nauseam, the line that most “active” managers don’t “outperform” the market.  This is the biggest lie ever perpetrated on the investing public in the history of investing!  Active managers ARE the market.  The “just buy the market” crowd has survived on what our good friend George Gilder describes as “parasites living off of the backs of active managers.”  Think about it, taken to its fullest extent, if everyone “indexed” (as the phenomenon is called) there would be no market.  Who would be responsible for price discovery, the government (scary thought)? Or the corporations themselves (talk about the fox guarding the henhouse)?  Along that line of thinking, the hysteria over indexing has reached such heights that there are those who have suggested that the very execution of “active management” is somehow promoting socialism.  Huh???!!!

It has grown in acceptance because Wall Street has abdicated responsibility for making investment decisions to the few, mass-managed money behemoths who dominate the so-called “active” investment management world.  Like in so many instances Wall Street, in general, is a victim of its own success.  It is simply too big to be able to adequately “manage” anymore so it has gone completely to financial engineering and trading on the institutional side of the business, and “wealth management” (financial planning) on the retail side of the business.  They simply aren’t training people to make real investment decisions.  By investment decisions, we mean, which companies deserve to have one’s capital.  We do not mean, which mutual fund or ETF should one buy, or to which active investment manager (like Taylor Frigon) should one outsource investment decisions.

Gone is the era of the “stockbroker”.  A much maligned figure that once stood tall in the world of managing money for people.  Yes they picked stocks, and yes they made their money on commissions for selling stock to their clients.  But, back in the day, good stockbrokers did research…real research.  They analyzed companies and made recommendations to their clients that they believed would make them money.  They followed the companies they had invested in (and the good ones invested their own money in the same companies as their clients).  And those that lasted in the business made their clients, and themselves, money.

While we subscribe to a different model of how we get paid today (an asset-based fee), which we feel more closely aligns with the client, we were fortunate to have learned our profession from one who was cut from a similar mold.  Richard Taylor was mentored by Thomas Rowe Price in the 1960s and learned how to buy businesses.  At that time, that is all you did if you were in the business of investing other peoples’ money.  The concept of buying the market was nascent, at best.  Thomas Rowe Price believed that the great fortunes that were made in this country were “made by men who retained ownership of great businesses, through market cycles”.  It is with this concept that we feel true investment strategies can be built.

Contrary to what many would like you to believe, this is not rocket science!  It is simply tedious, time-consuming and requires nerve, or a strong stomach, as the case may be.  Anybody can do it if they commit to a disciplined thought process.  Those who don’t can still hire people like us to do it for them.  While this may sound overly self-serving, it is meant to emphasize the point that part of the problem we believe exists in the financial world today is that most people have gotten too distanced from the investment decision-making process.  We believe this has ramifications for the general market and has held many companies back.  However, we think that it is changing and it will become more important than ever to be diligent about investing in businesses and not just blindly buying the market.  And this will not manifest itself in a massive crisis, but a slow burn that will cause one to wake up many years from now and either be bewildered by the lack of return in the “market”, or be comforted in the knowledge that you owned some great companies and built your own fortunes very nicely.
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Fed This, Fed That...

Once again the financial world, and in particular the financial media, are all in a tizzy over the statement that will be coming out from the Federal Reserve Open Market Committee (FOMC) later this morning, September 17, 2015, regarding the decision on whether to begin the long awaited end to the Zero Interest Rate Policy (ZIRP).  Anyone who has read our commentaries over the years knows that we think there is far too much emphasis on the actions of the Fed in determining the outcome of the economy.  We in no way suggest what the Fed does, or does not do, is immaterial to markets and the economy, but the idea that the Fed is the ultimate arbiter of economic growth, or lack thereof, is simply ridiculous!

As we have stated, it is our view that the Fed is long overdue in ending ZIRP.  In fact, we believe the economy could have withstood rate hikes as long as two years ago.  At the very least, during last years' surge of growth (Summer 2014), it would have been an excellent time to begin the process.  Now that they have waited so long, they have backed themselves into a corner and are headed towards raising rates at a time when global growth has slowed.  This is what we feared about waiting too long to get on with the process.  That said, regardless of the problems with economic growth in the emerging world, and in spite of what we admit is a subpar economic environment in the U.S.  and the rest of the developed world, we believe that further putting off the inevitable serves to retard growth even more.

There are many reasons for subpar economic growth.  We have pointed out in the past that the regulatory burden on business is far too high; that government intrusion in the private marketplace is onerous and government spending too large.  We have suggested that the tax code is far too complex and creates disincentives to economic activity.

All of these things are drains on growth and yet the amazing thing is that we are growing IN SPITE of all this nonsense.  It is the entrepreneurial economy that ultimately drives economic growth over time and at this point, the Fed raising rates .25% is absolutely irrelevant in that bigger picture.  In fact, they could raise rates to 1 or 2% and it would not stop the engine.  We think the signal it would send is that the constant vigilance over "looking for the next crisis" may be put to bed for a time, and that ultimately provides the backdrop to get on with fixing the things that are really holding us back from what should be an amazing era of growth, given the significant innovation that continues in the world of the entrepreneur.
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Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets

Linked above is the latest whitepaper from Taylor Frigon Capital Management, entitled "Toxic Bloom: How the unexamined dangers of ETFs threaten investors and the efficiency of markets," published on August 27, 2015.

In it, we compare the massive growth of exchange-traded funds (ETFs) within financial markets to a runaway "toxic bloom" of algae within a body of water, citing evidence which suggests that ETFs by their very nature may have extremely damaging effects on financial markets, impacting everyone who relies on those markets, whether investors in ETFs or not.

Back in July we published a post discussing several longtime concerns we have had regarding ETFs, especially in light of some high-profile comments by well-known investor Carl Icahn, who was himself raising a warning about ETFs (and specifically about ETFs designed to try to track inherently illiquid securities such as high-yield bonds).

At the time we wrote that July post on ETF dangers, we decided that we should also publish a more extensive "whitepaper" discussing the specific aspects of ETFs which we believe are potentially hazardous, and providing some explanation of just how ETFs are basically structured.  

A big part of the reason for writing such a paper: we don't believe investors in general have a very good grasp of exactly what an ETF really is, and how it is related to the so-called "basket of securities" to which it purports to provide investment exposure. 

In fact, we actually believe that very few financial advisors who employ ETFs as part of the strategy that they recommend to clients fully understand ETFs, or understand the fact that the only linkage between the price of the ETF that they recommend to their clients, and the market value of the "basket of securities" that the ETF is supposed to be tracking, consists of the willingness of certain big financial firms to engage in arbitrage-driven trading activity.

Just as we were completing this paper, and before publishing it today, new evidence emerged which illustrated this phenomenon rather dramatically. During the plunge of the US stock markets at the open on Monday, the price of many ETFs plunged far more than the drop in the market value of the securities that they were supposed to be tracking, coming "unhinged" by a wide margin and causing serious consternation among those who owned shares in those various ETFs (here is a story discussing this ETF disconnect in the Wall Street Journal -- and there are many others).

The drop was so severe -- and the "gapping downwards" so rapid during the day -- that many investors and financial advisors who had placed stop orders and market orders to sell had those orders execute at percentages below the price they thought they would get for the trade, by 20% or more in some cases. The fact that many financial advisors placed stop-loss orders on these ETFs, and the fact that some are quoted in that article as saying the price drops and gapping of the ETFs that they saw that day "don't make any sense," tends to confirm the allegation that many financial advisors do not actually understand the principles of arbitrage and liquidity upon which ETFs by their nature must depend in order to keep the price of the ETF in line with the price of some basket of securities.

When liquidity becomes scarce -- or when the big Wall Street firms who are authorized to make those arbitrage trades for the ETFs decide to "step aside" and not make those trades (for whatever reason, usually because they see that there is not enough liquidity) -- then the price of the ETFs become unhinged in exactly the manner that was witnessed on Monday. 

In other words, that kind of "gapping" makes perfect sense: it is a product of the well-known laws of supply and demand, and is generally the way that prices will move in a market from which liquidity vanishes.

We believe that the tremendous growth of ETFs poses significant hazards -- and academic papers cited in the above whitepaper suggest that these hazards may in fact impact the wider market and not just ETFs. 

We believe that understanding how ETFs work is an important step towards trying to address some of these hazards.

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A Hissy Fit In The Market

The market opened this morning in a very chaotic manner which is indicative of the kind of reaction that comes from a market which is dominated by trading and non-economic decision-making versus investment based in business fundamentals.  Quite timely given our commentary recently about the disfunction caused by the ETF phenomenon.  Incidentally, even the talking heads on CNBC were referencing the potential that ETFs could be at the heart of the "dislocation" that seemed to be occurring in the trading apparatus this morning.  

Who really knows?  And that is not comforting!  

However, it is not as if we haven't seen panic-type markets before.  We experienced the one day drop of 22% in the DJIA in 1987 and the wild swings in 2008-2009; much more severe than today's move.  And since then there have been several "headline events" such as the Greece debacle, Dubai Ports World, disruption in Cypress, geopolitical tensions in the Middle East, just to name a few.  This underscores the need to be centered on a long term investment approach, similar to that which we provide.  One which is based in sound fundamental research and is not dependent on the move in stock prices on any given day, week, month, quarter or year, for that matter!

Ironically, this down move across the board is happening at a time when we think some of our most important themes are showing signs of kicking in after being on hold for the last couple of years.  These would include the transformation towards virtualization across the data center universe, the advent of sensor technology in wearables and the "Internet of Things" (IoT), the transformation of the enterprise into a fully cloud-based platform, and others.  

These are just some of the business innovations that we are focusing on at this time.  We expect that regardless of where the markets ultimately settle today, this week or this month, these trends are and will continue to be powerful drivers of business and ultimately portfolio returns in the years ahead.

That said, we have warned in previous commentary that the market may throw a "hissy fit" when the Fed decides to finally raise the target for the Federal Funds Rate from zero.  This may be that "fit"!  Followers of our commentary know that we have been advocates for raising rates for some time and it would seem the Fed is finally ready to acquiesce.  While it is impossible to say that when the Fed meets in September they will definitely raise rates, it is likely to happen by the end of the year.  Will there be more market turmoil when the event finally comes to pass?  Possibly, but likely the "return to  normalcy" that a Fed rate hike would bring will ultimately allow the market to move higher as it turns its focus back to business, where it belongs.

Whether or not recent market weakness is solely due to the expected actions of the Fed, or China's so-called meltdown, not all that unusual for a market that has had a meteoric rise in just a matter of months, the key is to be centered and still in volatile times, and even look to buy great businesses while they are on sale!
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Carl Icahn says what he means on a very important subject: all investors should pay close attention

We have been concerned about the rapid rise in popularity of exchange-traded funds (ETFs) for a long time.  Over ten years ago, at a conference on the topic of ETFs, we were given a book that explained how they worked and how to use them in strategies; the book was almost 700 pages long.  It struck us that any investment vehicle that took 688 pages to explain was problematic.

This past Wednesday, July 15, there was an extremely interesting conversation at the "Delivering Alpha" conference in New York City, hosted by CNBC and Institutional Investor, in which investor Carl Icahn raised some extremely important points about ETFs which we believe every investor should consider very carefully.

During a panel which was apparently going to be about "investor activism," Carl Icahn made some very hard-hitting remarks about dangers posed by ETFs (exchange-traded funds) and most particularly the danger that ETFs may be seen by many investors as offering a degree of safety and a degree of liquidity which they do not possess.

This subject is one of tremendous importance because ETFs have grown to be an enormous segment of the global and US investment markets in both stocks and bonds and also in commodities. According to the Investment Company Institute, there are about $2.7 trillion invested in ETFs world-wide, about $2.0 trillion of which are in ETFs based in the US.

Therefore, when Carl Icahn (whose professional investment career started in the year 1961, and whose company Icahn Enterprises manages over $24.5 billion in assets) says that he believes ETFs are perceived as having a level of safety and a level of liquidity which they do not possess, we believe investors should pay very close attention to what he is saying.

While the discussion between Mr. Icahn and BlackRock CEO Larry Fink included a debate about whether higher interest rates are going to negatively affect high yield bond prices, that was really a sidelight to what we feel is the more-important discussion about the perception that ETFs are safe, liquid investments that are inexpensive and “easy” for the average investor to “own."

It is this last point that we feel is the most important, and wasn’t directly addressed by Mr. Icahn -- although he did make reference to the fact that in order to discuss what's going on inside an ETF he "could get into some arcane stuff" -- is that the “investor” is really not “owning” anything when “investing” in ETFs.  At its core, the ETF is just another form of derivative.  If there is anything the 688-page book taught us it is that it is not the average investor, but rather the supporting banks that can “ask for their shares” at any time from the funds.

As advocates of true price discovery, it occurs to us that the farther away the so-called “investor” is from the ownership of the investments they think they are making, the more potential pitfalls there are when times get tough.  This is why an investor with the stature of Carl Icahn making points about the pitfalls of ETFs is worth noting.

You're welcome to skip down and watch the videos at any time -- here, in a list format, are some of our thoughts and comments about this very important subject:
  • At Taylor Frigon Capital Management, we invest in companies directly, by owning individual securities issued by those companies. This means that we are obviously biased in this argument, because we compete against investment advisory services using ETFs. But we could have chosen to use ETFs if we wanted, and after significant analysis decided that, at best, the underlying complexity was problematic, and at worst, the ETF is a potential time bomb that may have systemic implications if they continue to grow without adequate understanding on the part of investors as to exactly how they work.
  • While we don’t likely agree with Carl Icahn on everything, we do invest in individual companies on behalf of our clients, including some companies in which Mr. Icahn, through Icahn Enterprises, is a very large shareholder, such as Apple (AAPL) and CVR Energy, Inc. (CVI).*
  • We also believe in investing in those companies directly for both our clients and ourselves.
  • We believe that Carl Icahn is doing the investment community a great service by forcefully calling attention to what he believes is a potential problem: the fact that investors may be mistaken in attributing to ETFs a level of safety and liquidity which may be unwarranted (specifically with regards to ETFs which own an inherently illiquid and sometimes risky investment: high-yield bonds). Note that Carl Icahn says in some of the video segments below that he feels some remorse for not being more outspoken about concerns he had prior to 2007 and 2008 about a different category of pooled investment vehicles, but that he wants to say now very clearly that he perceives some potential problems of a very serious nature (while not specifically predicting any sort of immediate crisis).
  • Although Carl Icahn did not specifically say it -- and this post is not intended to imply that he did -- we believe that some of the same criticisms that he applies to high-yield bond investing through ETFs can be applied to many other types of investing through ETFs. Specifically: just as Mr. Icahn is saying that investors in high-yield bond ETFs feel a certain "distance" from the underlying security (in this case, high-yield bonds) and don't feel that they need to perform the kind of individual due diligence on each individual security connected to that ETF, and just as investors in those high-yield bond ETFs feel that the ETF makes high-yield bond investing more liquid and more safe than individual high-yield bond investing (but the reality may in fact be quite the opposite), we believe that investors in almost any kind of ETF including those which invest in stocks end up distancing themselves from attention to the specific business factors of the business in which they are investing. And we believe that this can be a dangerous pattern, no matter what the underlying investment happens to be.
  •  We also find it interesting that some of Mr. Fink's comments in the video can be seen as indirectly or perhaps unintentionally providing support for the point we just made. For instance, in the very first clip beginning about 10 or 15 seconds from the start of the clip (before Mr. Icahn even begins his hard-hitting criticism of ETFs), he says (as a function of how much his investment management firm manages in index funds):
So, we have to own companies that are poorly-run, and companies that are well-run. We own all the companies [expansive hand gesture]. Unlike active investors -- and a lot of our money . . . we manage active, too -- our investors can't sell those stocks if they hate the company. We're only . . . we have to own the stock whether we like it or not, and the . . . so, we have a much greater responsibility in working with companies, and hopefully over time working with the companies to build the proper returns that we expect from them. And then sometimes, we will even agitate, but we will do it privately and quietly. [Punctuation in the above quotation uses ellipses to indicate a pause or a change in direction of the sentence, and not to indicate words omitted from the quotation: no words were omitted from the quotation in the clip, as we hear the audio].
  • We find that admission to be a pretty good description of what we believe is the core problem with the whole category of index and ETF investing. The premise on which these forms of investment are built is inherently opposed to the kind of scrutiny of the underlying investment (whether it be a stock issued by a company, or a high-yield bond) that we believe is the very heart of responsible investment.
There is much more that could be said about some of the many important related subjects raised during this exchange between Carl Icahn and Larry Fink. However, we believe that this one central issue -- about the perceived safety and liquidity in an investment vehicle which makes up an enormous percentage of the global investment landscape -- is the issue that investors should take the time to consider very, very carefully.

Towards the beginning of his own remarks, at the start of the second video segment, Carl Icahn says: "And I really mean this -- I'll just say what I mean. I'm too old not to say what I mean, and I don't hold back."

No matter what your opinion of Carl Icahn or of what he says after that, you have to respect him for making that statement, and then for very bluntly "saying what he means" because it is what he believes investors need to hear, and what investors need to know.

And when someone with as much market experience and success as Carl Icahn has, sits down and very plainly tells you that he is going to freely say what he means, we think investors should pay attention. And we applaud him for doing it.

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* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by BlackRock (BLK). At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Apple (AAPL) and by CVR Energy (CVI).
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Why Employers are Rethinking Turnkey 401(k) Plans

Turnkey retirement-plan programs sounded like a great idea.

When fund companies and other big firms started offering them in the 1990s, employers were promised solid employee benefits delivered with groundbreaking simplicity and low cost.

What was not to like? Plenty, it turns out.

Turnkey plan providers like to boast about the number of funds they make available to employees. The typical plan now has hundreds of options. Yet this abundance hasn’t benefitted the typical employee: To the contrary, it’s led to employees feeling overwhelmed.

Too many choices have led to paralysis, with employees simply leaving their contributions in cash. That’s certainly not going to help them earn the returns they need to retire one day.

Second problem: Turnkey providers are failing to educate plan participants. Employees need a clear understanding of setting goals and investing properly to achieve them. And since they’re bombarded with daily headlines about the markets and investing, they need to be continually reminded about the difference between impulsive trading and sound long-term investing practice. That’s rarely, if ever, taking place. We’ve even heard of employees making daily changes to their 401(k)’s, a practice that usually backfires badly.

Finally, turnkey plan providers were supposed to help plan sponsors stay on top of their administrative responsibilities. All the feedback we hear from small and mid-size employers is that it’s not happening, and that important tasks are regularly falling through the cracks.

All of that helps to explain why some employers are seeking out alternatives to the giant turnkey plan providers. They’re taking a closer look at companies like Taylor Frigon, where our team offers something very different from the industry norm.

Our investment lineup for 401(k)s consists of just four funds: a growth strategy, an income strategy, a default strategy featuring a conservative balance of investments, and a money-market fund. The size of our menu is a direct reflection of our conviction that managing risk and capturing growth is best achieved by holding a moderate number of carefully chosen investments. (Read more about diversification here.)

This compact fund menu not only simplifies investment decision-making for plan participants, but it virtually eliminates the temptation to jump from fund to fund.

Then there’s education. To give participants a real shot at successful retirement investing, personal and ongoing education is essential. We personally visit clients at least twice a year, explaining how important it is to avoid “playing the market,” and to invest in good companies for years, not quarters.

We’re proud that our education helps to counterbalance the hysteria that plan participants are subjected to from the financial shout shows, from print advertisements and even from their friends and neighbors. Investing is simple—it’s investors who tend to make it difficult.

On the administration front, we partner with third-party administrators to provide a high-touch, personalized level of service. Employers who hire turnkey providers too often find their “partner” is a bureaucratic machine that isn’t concerned with their peace of mind. While turnkey programs may charge less for administration, that advantage can be easily negated through penalties for compliance shortfalls.

No employer wants their plan participants to be confused and overwhelmed. And they certainly don’t need avoidable compliance headaches. This explains why more are considering leaving faceless turnkey plans and looking to get back to basics: A clear investment path, real education and solid support.

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How Diversification Became “Di-Worsification”

Charles Dickens once wrote that virtue, carried to excess, could become vice. 

If he were a modern financial expert, Dickens could be talking about portfolio diversification. Diversifying the kinds of assets you hold helps you to maximize potential gains and minimize risk. But when diversification is carried too far, it becomes “di-‘worse’-ification.” 

Having too many investments in a portfolio eliminates both the potential for extra gains and the protection against excess risk. And yet that’s exactly what countless investors, and even advisors, are doing. Building portfolios with hundreds and hundreds of individual investments, they’re champions of the idea that there can never be too much of a good thing. But they are dead wrong.

True diversification involves counterbalancing types of assets that behave differently in different market conditions. By investing in assets with less correlation to each other, we gain exposure to a cross-section of growth opportunities. And because all our eggs are not in one basket, our portfolios may be insulated against a crash in any one asset class.

Diversification isn’t just some kind of popular wisdom—it’s rooted in respected academic research. The Fundamentals of Investments for Financial Planning, published by The American College, explains that true diversification doesn’t require a myriad of investments: “Research has repeatedly shown that a relatively small number of stocks (about 30) is sufficient to obtain most of the risk-reduction potential of diversification.”

When a portfolio exceeds that number, diversification’s benefits vanish. Specifically, the portfolio becomes increasingly exposed to market volatility. In plain terms, the more of the market you own, the more your portfolio will simply mimic the market. Your optimized balance between risk and return will disappear, so that when markets go down, up or nowhere, your portfolio will do the same. 

Then there’s the matter of costs. The more securities or funds you own, the more you are paying in sales and management fees. Especially in today’s modest return environment, these fees can eat up a large percentage of your returns. What’s more, the complexity of over-diversified portfolios makes them difficult to analyze. Which investments are helping and which are hurting? With hundreds upon hundreds of possibilities, it can be nearly impossible to tell.

One reason over-diversification is so prevalent is that many advisors “diversify” their client portfolios using mutual funds. A typical advisor may recommend a large-cap fund, a mid-cap fund and a small-cap fund. He may balance out a “value”-style fund with a “growth” style fund. He may add additional funds to gain international and emerging-market exposure. 

With each fund holding 50 to 100 stocks, you may soon be di-worsified into a portfolio with thousands of individual securities. That becomes a recipe for mediocrity at best, and disaster at worst. 

At Taylor Frigon Capital Management, we adhere to diversification in its true sense—and to some people that seems radical. We manage just two strategies: our Core Growth Strategy, which currently has 38 holdings, and our Income Strategy, which current has 42 holdings. 

Together, these two simple, straightforward strategies contain about 80 securities. Each strategy is fully diversified and constructed to complement each other to offset risk and optimize reward.  

Our approach, using rigorous in-house research to identify a limited number of exceptional securities across industries and sectors, has been validated by performance. From its inception on January 19, 2007, through the first quarter of this year, the Core Growth Strategy has posted an annualized return of 8.34% after fees. By comparison, the S&P 500 has returned 6.87%, and the Russell 3000 has returned 7.19%.

Our Income Strategy, built to deliver consistent cash flow and dampen volatility, has returned an average of 5.29% per year over the same period, after fees. That’s competitive with the S&P 500’s return—with much less risk. 

Past performance does not guarantee future performance, in our strategies or in any investment (for our performance disclosure, please click here) . But we believe our streamlined strategies are a testament to the power of diversification at its best. Please feel free to contact us for more information.

Main Points: 

  • Excess portfolio diversification becomes counter-productive “di-worsification.”
  • Di-worsification eliminates the valuable balance of risk and return and exposes investors to increased risk.
  • Diversification is most effective when portfolios consist of 40 individual holdings. 
  • Excess diversification creates more risk, higher costs and more confusion.
  • Di-worsification often occurs when advisors recommend multiple mutual funds.
  • Taylor Frigon strategies have achieved strong results with “pared-down,” true diversification.
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Frigon highlights tech companies on radio interview

Recently, TFCM's CIO Gerry Frigon was interviewed by our own John Summer on KVEC radio in San Luis Obispo.  Mr. Summer was guest hosting for Dave Congalton as he discussed Taylor Frigon Capital Partners' most impressive technology companies.  You can hear the interview on this podcast, starting at 1:00.
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QuickLogic (QUIK): a venture capital-style opportunity for public market investors (RESEARCH)

QuickLogic (QUIK): a venture capital-style opportunity for public market investors, offering a solution for the incipient flood of sensor data 

Bottom Line: QUIK is trading at 5-year lows, having been sold off successively in recent weeks for guiding lower than investors expected, and then announcing the departure of their CFO. We believe the company has significant potential, and that the story is not widely nor well understood.

Summary: QuickLogic is an unappreciated semiconductor company positioned in front of a major opportunity in the nascent mobile sensor processing solutions market. In a situation similar to the types of investment opportunities that venture capitalists find interesting, the company is currently valued under $100 million and has a viable solution that addresses a new market the size of which is difficult to determine because it is just now beginning to take shape, but which may be in the billions per year. Of course, in most situations involving a small company with a potentially market-shifting technology, there are plenty of risks, including execution risks; risks that other technologies or approaches might eventually win out; as well as all the risks that come along with the situation of being a tiny company selling into the piranha-tank of the mobile consumer device market dominated by big-name consumer-device OEMs, cut-throat competition and pricing, and fashions and trends that change literally from week to week. (An OEM is an “original equipment manufacturer,” and an ODM is an “original design manufacturer,” and both types of companies are potential QUIK customers. During this report we will simply use the abbreviation “OEM” to refer to QUIK’s customers, who design and/or make mobile devices). 

Unlike a venture-backed start-up, however, the company has a market-proven technology, major customers including Samsung with more big-name customers expressing executive-level interest in their product, revenue run-rates of around $20 million per year or more, over $28 million of cash on the balance sheet, low probability of requiring a future capital raise in order to stay in business (although the company is currently not at break-even yet), and a very experienced management team with decades of industry background in Silicon Valley. 

The stock has been severely hammered in recent months, currently trading around $1.70 and reaching lows below $1.60 in the past twenty-four hours, off of 52-week high of $5.48 in June 2014. On 05/06/2015 the company announced the departure of the CFO, leading to another selloff on 05/07. 

We believe the company management is honest, capable, and has a valid strategic plan which involves the potentially enormous market for sensor data processing solutions in mobile devices containing sensors (a market that is in its early stages now but which will almost certainly be getting much bigger from where it is today), and that the company’s technology addresses a major issue that is on the forefront of every engineering design team in the mobile device business today – power. Further, the company’s silicon has specific architectural advantages which makes their solutions unique and difficult to replicate by competitors. Their solutions are programmable, which is another major advantage, and the company has developed a library of software algorithms which offer added value to OEMs seeking to differentiate their products in the fast-moving and highly-competitive markets for smartphones, tablets, and now wearables.

As the discussion below should make clear, it requires a fair amount of rather arcane technical discussion to understand some of the important aspects of the company’s technology and its advantages in the market that is now developing. While the discussion below is fairly lengthy and somewhat technical, it is only a very simplified version of the big picture. We do not believe that some of the more granular details of the QUIK investment thesis are well understood: in fact, we believe that the company is widely misunderstood, as well as being simply too small to notice for many institutional investment managers and large sell-side research departments.  However, we believe that the company’s technology has significant advantages which are well positioned for an upcoming market in “always aware,” sensor-rich devices, and that the companies which make these devices will likely have to consider QUIK’s solutions because of the power-efficiency advantages that QUIK offers, as well as the flexibility, customizability, time-to-market, software algorithm, and product-roadmap advantages that are equally important but also not obvious without some familiarity with the industry specifics.

Please refer to IMPORTANT DISCLOSURE INFORMATION at end of this research.

Basic Description: QuickLogic is a fabless semiconductor company that designs programmable semiconductors and the associated software that OEMs who use their semiconductors need in order to incorporate those semiconductors into their products. The company produces several product lines, almost all of which are characterized by the use of programmable logic (similar to an FPGA but with some important technical differences), and some of which also incorporate certain hardened logic blocks which are not programmable but which perform pre-selected tasks using hardware for greater power efficiency. Additionally, the company designs software algorithms which function as drivers for the hardware, and which in some of their recent products also offer OEMs a selection of algorithms to perform important consumer-facing functions such as voice-recognition applications, gesture-recognition applications, navigation applications, as well as algorithms for future capabilities that few or no mobile devices and wearables on the market today are even capable of offering. The company outsources the fabrication of their wafers to manufacturers such as TSMC, eSilicon, Globalfoundries, and TowerJazz (JAZZ).

Selected income statement items for the past nine quarters are shown below:

Revenues by geography for the most recent quarter were 62% Asia-Pacific, 30% North America, and 8% Europe.

Business Opportunity and Investment Thesis: Founded in 1988 and headquartered in Sunnyvale, California, QuickLogic pioneered a type of programmable silicon in the family of programmable logic that also includes the more-familiar FPGAs and PLDs marketed by XLNX, ALTR and LSCC, but Quick’s approach had its own set of specific strengths and features including certain power-efficiency advantages. For many years, especially before mobile markets made low power-consumption the kind of critically-important feature that it is today, QUIK mainly sold into military and aerospace markets that needed certain other features that their type of programmability could offer, but outside of these markets QUIK’s advantages were not that critical, and although the company’s stock did run up with other technology companies during the late 1990s and early part of the 2000s, its “legacy” applications did not offer particularly high growth potential.  

More recently, however, QUIK’s programmability and power-efficiency has become much more interesting, as the market for mobile connected devices which did not even exist until about ten years ago has made some of their unique features more attractive to potential customers. QUIK has applied these strengths to the mobile market to offer bridging and connectivity solutions in phones and tablets. 

Bridging solutions refer to the use of an intermediary processor to act as a “display bridge” between an apps processor (the central processor in a phone or a tablet) and the display, almost like a translator between two people speaking different languages. Apps processors are often mass produced with a certain type of display output that does not match the type of input needed by the silicon that is governing the screen display. A display bridge can be a much more practical solution than trying to find (or design from scratch) an apps processor that “speaks the desired language” of the display that the OEM wants to use.

Other common mobile market uses for programmable logic of the type that QUIK offers include solutions for OEMs needing a rapidly-deliverable “fix” or “workaround” for a product going to market. These types of product applications will probably always be a steady source of some revenues for QUIK, but in each of the situations just described, it is likely that the “bridging” or other connectivity “fix”  may be designed-out of future generations of the same product (when the functionality is absorbed into the apps processor, for example). When tablet OEMs including Samsung began using QUIK silicon for connectivity and/or display-bridging roles in previous quarters, revenues spiked, investors began to take notice, and the stock ran up to its 52-week highs (following the record-high quarterly revenues of $11.16 million in the March quarter of 2014). As these more “short-lived” uses for their programmable solutions were designed-out of later generations of some of their initial mobile customer products, however, and as tablet sales globally hit a major decline in the second half of 2014, QUIK’s stock price underwent a similar collapse.

However, while these “shorter-lived” mobile applications for their silicon’s unique advantages have been the main focus for momentum investors in the past 52 weeks (whose interest has also been quite temporary), and while there will probably always be an ongoing market for the kinds of “short-lived” workaround solutions that QUIK’s power-efficient programmable logic can offer to OEMs with these kinds of product needs, the management team of the company has quietly been steering towards a new opportunity that is still in its very early stages: extremely low-power, customizable sensor data processing solutions for the fast-approaching flood of sensor-rich data that is on its way in the near future. In this regard, QUIK’s solutions have the potential to help engineers and product design teams at the OEMs to address two dilemmas which are already problematic but which are likely to become even more pressing as data-processing demands on mobile devices increase.

As devices perform more tasks, processors must execute more duty cycles, and they use electrical power in order to do so, draining the battery and generating heat in the process. There are “hard limits” to how much heat a mobile device can generate before it becomes a problem (you don’t want to burn your customer’s face, for example), and there are also hard limits to how long a battery will last as the processors in the device are called upon to perform more and more duty cycles (after a certain point, the battery will have to be recharged). Engineers and architects are faced with conflicting demands: the device is expected to do more delightful and amazing applications, powered by a smaller and smaller battery that holds less and less charge (the Apple Watch, for instance, appears to contain a 205 mAh battery according to this teardown from iFixit), while users want to go longer and longer between charging periods. This conflicting set of demands poses something of a dilemma for OEMs.

Those demands (driven in part by the desires of the owner of a mobile device such as a smartphone, tablet or wearable, and in part by the engineering realities of amps, battery capacity, and processor duty-cycles) are fairly straightforward and have been part of the picture at consumer device companies for some time, although there are important reasons (hint: sensors) why the processor demands in the first part of the equation may be getting ready to increase dramatically, at the same time that the demands for lower power envelopes using smaller and smaller batteries (hint: wearables) and longer times between charges are also getting more and more insistent. QuickLogic’s leadership recognized that their technology’s unique strengths may be perfect for addressing these conflicting demands.  

There is another set of conflicting demands creating a dilemma for OEMs, which QUIK’s capabilities can help solve. The companies that design and sell mobile devices face vicious competition in the mobile consumer device landscape (whether in smartphones, tablets, or the new and as-yet unproven market for wearable devices). They want to produce a device that has unique or differentiating features, with delightful built-in applications or algorithms that will make their device stand out from the others or make the owners of those devices happy and loyal. But they also have to bring those products out in a very short product-cycle, with “new generations” of phones and tablets being released about twice a year at the big top-five device companies (even faster than the cycle for new cars, for instance). Additionally, the OEM needs to be able to deliver these new, differentiating features in a cost-effective manner. So, they are facing a need for differentiation, inside this incredibly rapid product-cycle, with the need to be as cost-effective as possible so that they can offer the product at a competitive price.  These are very real and pressing concerns for OEMs, and once again QUIK’s fairly unique hardware background enables the company to offer some solutions that help solve this second OEM dilemma.

That’s two dilemmas OEMs are facing.

At the risk of oversimplifying somewhat, the aspects of QUIK’s silicon solutions that make them attractive to OEMs (because they help overcome the two dilemmas) include:

  • QUIK solutions offer programmable logic. Some of it is one-time programmable, and recently the company developed fully reprogrammable logic as well. This makes their solutions customizable and quick for an OEM customer to bring to market – even within the short product-cycles that have come to characterize the competitive, high-profile world of consumer mobile devices such as smartphones, and it also makes them cost-effective. In contrast, non-programmable preconfigured architectures such as ASICS would be prohibitively expensive to customize for most consumer devices, and the time it takes to design and bring them to market would also be prohibitively lengthy.
  • QUIK solutions also offer hard-wired “proven system blocks” or PSBs that they put right onto the same chip with the programmable logic. These PSBs are already hardwired and are not programmable: they resemble some of the characteristics of ASICs in that regard. These PSBs are hard-wired to perform certain tasks that QUIK has found many OEM customers want, but OEMs can basically choose from a “menu” of PSBs to add on to their chips. Moving some functions to hardwired PSBs lowers power dramatically, and also speeds up time-to-market, while still allowing some customizability through the use of the “menu.” By offering both programmable logic and PSBs together, QUIK can offer the advantages of both and help overcome the dilemmas described above, and in particular this set-up enables rapid time-to-market plus differentiating customizability plus cost-effectiveness, all at lower power than competing solutions.
  • QUIK offers processors which can offload specialty tasks from the central apps processor in order to save power, which will become more important as OEMs design more devices to be “always aware.” Running an apps processor constantly in order to keep a device “always aware” of its contextual surroundings would rapidly deplete the battery, because even as apps processors become more power efficient, they must by nature be flexible and capable of handling a wide variety of general purpose processing tasks, and fast enough to do those tasks in ways that will not annoy the user or delay the applications they are designed to handle, and therefore they cannot be optimized for power to the same degree as the more specialized processors such as those QUIK offers. The increasing demand that devices become more aware of their surroundings, which they do through the monitoring of sensor data, has already forced some of the leading-edge smartphone makers to incorporate a separate processor usually referred to as a sensor hub to monitor the sensor data and do certain types of processing to that data rather than making the apps processor handle it all. The sensor hub can monitor the sensor data and keep a low level of “always-on” awareness, and let the apps processor stay asleep until absolutely necessary, thus adding greatly to battery life and power efficiency. Apple introduced a sensor hub in the iPhone 5, for example.
  • QUIK offers a power-efficiency profile that is vastly superior to most competing solutions – orders of magnitude better in some cases, particularly as demand for processing becomes more significant (the magnitude of the improvement that QUIK can offer in this department is graphically illustrated by some graphs included in the more product-specific discussion below). One of the ways that QUIK’s solutions achieve much better power efficiency than competing architectures is their use of a different architecture which they believe offers much lower power-consumption. In fact, at this time there is data which suggests that all other architectures are facing a power wall that will make it difficult to continue adding sensor-enabled features, at the same time that forward-leaning mobile device OEMs are beginning to incorporate more and more sensors into their products. This paper from QUIK discusses the different architectures used by different processor designers on the market today, and why QUIK’s architecture offers greatly increased power-efficiency compared to other approaches.    
  • QUIK offers a robust set of software tools to enable OEMs to use QUIK’s hardware, further enabling them to use QUIK’s silicon and have it “talk to” and interface with other players inside the device. Some of these are “drivers,” which are analogous to the drivers we all use from time to time when we buy a new printer and want to enable it to interface with our laptop or desktop or tablet’s operating system. It wouldn’t be a very good idea for printer-makers to try to sell a piece of hardware that couldn’t interface with the software on a wide variety of other systems that their customers need it to be able to talk to. QUIK’s devices are programmable using C and C-like code which means that they can be manipulated, reprogrammed, tested, and debugged by many coders at the kinds of companies that would be using QUIK solutions, and that firms do not have to hire specialty personnel with skills in rarely-used coding languages in order to use QUIK products. Additionally, it also means that OEMs who use QUIK products will be able to transfer or “port” the code that they wrote for other QUIK products or for previous generations of QUIK products onto newer generations of QUIK products going forward into the future. There is a QUIK “roadmap” for customers to see the capabilities that are planned for future generations of processor solutions, so that customers can be confident that as they themselves want to introduce new generations of products, QUIK will have new solutions that will support new improvements and added functionality.
  • QUIK actually sends their own engineering teams to work together with the OEM’s engineers in order to make the integration of their products more successful and easier for the customer, especially for customers who need to design specific customized features. As has already been discussed, there is already a “menu” of “pre-loaded” features that customers can select in order to build a kind of unique and differentiated set of features, all of which are already basically “ready-made” by QUIK and don’t require a lot of design and added coding by the customer, but QUIK provides a full sales-support cycle to help customers ensure they get the solution that they are looking for.
  • In addition to the types of drivers and functionality-interface coding described above that QUIK has been offering on products for years, QUIK has now developed a specific set of sensor algorithms called the SenseMe library of algorithms, for use with their new sensor processing solutions targeting the nascent sensor processing market. This algorithm capacity is a major differentiator for QUIK in comparison to competitors who are offering a simple hardware sensor hub.  With a simple sensor hub, the task of either creating algorithms for the sensor hub to use in order to make use of the sensor data, or buying third-party algorithms from a software design company and putting those onto the sensor hub falls to the OEM company, some of which have their own algorithm teams (mostly only the top-tier OEMs) and many of which do not. By developing their own high-quality in-house algorithms, QUIK is offering much more than just a sensor hub product (even though their product is significantly lower power, faster time-to-market, etc). By virtue of their algorithm capability and sales-support tradition, QUIK is offering an entire solution and not just a hardware product – QUIK calls them “sensor processing solutions” as opposed to simply “sensor hubs.” It is a hardware and software solution, with design-integration assistance throughout the life-cycle of the sales and design process with the OEM customer. This adds yet another layer to what is already a very compelling value proposition. We believe QUIK’s products would be compelling enough just on the advantages of programmability and power-efficiency, but when the value of the algorithms and the “complete solution” approach is considered, we believe that QUIK could and will find some way to benefit from the tremendous added value that they are now bringing to the marketplace.

QUIK’s lineup of sensor processing solutions:
QUIK has several lines of programmable processors suited for the different general applications described briefly above, some of which allow the customer to write their own code and add their own unique functionality, and some of which offer pre-loaded PSBs so that customers can get “off-the-shelf” functionality for certain frequently-requested processing tasks. Interested researchers can look at discussions of these product lines on the QUIK website and in their various filings, whitepapers, and other publications. However, in this particular discussion we will focus primarily on QUIK’s most-important future growth opportunity, in our view: the sensor processing solutions designated by the letter “S” in the QUIK product nomenclature, and specifically their current-generation solution dubbed the ArcticLink-3 S2 (which we will simply refer to as the “S2” in this report), and the next-generation solution due out later this year, the ArcticLink-4 S3 (which we will likewise simply refer to as the “S3”).

As discussed briefly above, these processor solutions are designed to help OEMs who are designing mobile products that contain various sensors which need higher levels of monitoring and “data-fusion” tasks, particularly OEMs designing smartphones and wearables but also potentially tablets or other mobile devices containing sensors.  We are all familiar with mobile devices containing sensors: most smartphones and tablets, for instance, will “rotate the screen” based on their awareness of the way you are actually holding the device from one moment to the next, and the way they “know” is generally through data provided by a now-ubiquitous type of sensor called an accelerometer. Note, however, that this accelerometer does not need to be sending data to the device’s central processor (called the “apps processor” in the mobile world, or simply the AP) every second of every day: it only needs to do so when you are actually looking at the screen and the screen is lit up. For much of the day, whether the device is sitting on your desk or in your pocket, purse, briefcase or passenger’s seat, the screen may be off and the accelerometer and the apps processor can be resting.  

Because of this fact, device designers have often been able to get away with using no dedicated “sensor hub” at all – perhaps the apps processor could handle the sensor data when data is actually coming from the sensor, without draining the battery too rapidly or causing too much of a strain on the apps processor and its ability to handle other tasks. However, as devices begin to incorporate more and more sensors, and as OEMs and apps developers begin offering functionalities that people might find useful but which require sensors to be monitored more frequently or even monitored on some level all the time, it will become more difficult to use the AP alone for all this sensor data. This is because the AP for various very good reasons is usually not the most power-efficient processor type for these tasks, since it is optimized to run different kinds of apps for the device and the user.  It is for these reasons that some devices have already begun using a sensor hub. We will see that the kinds of sensor hubs in use today, while capable of handling the current sensor-related functions of this generation of smartphones, will probably choke on the levels of data that will be coming soon (or at least break the “power budget” of the battery, leading to bad product reviews from users who complain that the battery does not last as long as advertised and that they have to charge it up more frequently than they would like to, etc).

The QUIK S2 solution is designed to handle the types of sensor-data processing demands found on even the most advanced smartphones and wearables on the market today, and even to handle far more sensor data than what is available on any smartphone or wearable today (yes, even that one), and to do so with far better power efficiency than the commonly-used microprocessors which competitors (such as ATML, with their RISC-based M-series sensor hub microcontrollers, including the lower-end M0 and the state-of-the-art M4F) are offering. It can handle up to twelve sensors on a single device, and is capable of handling data sent from any of the most-common types of sensors available to OEMs today, including accelerometers, gyroscopes, thermometers, magnetometers, heart-rate monitors, pressure sensors, UV spectrum sensors, gas detecting sensors, humidity sensors, ambient light monitors, proximity sensors, and others.  It is fully compatible with most versions of the Android OS up to and including Lollipop 5.0, and with RTOS-based systems (“real-time OS”-based systems) 

The S2 uses only 93 microAmps (μA) at 1.2 volts. Remember that watts are the measure of power, and in this case are found by multiplying the amps of electric current times the volts of electric potential, meaning that at 1.2 volts the S2 uses 111.6 microwatts. Recently, QUIK announced a newer version of the S2 which uses even lower power, dubbed the S2 LP, which uses only 76 microAmps at 1.2 volts.

The amount of microwatts that the S2 will use inside an actual device will depend on the number of “instructions per second” that the processor has to process, which is a measurement of the load on the processor referred to as the “duty cycle.” The duty cycle required will be dependent on the number of times the sensor “samples” per second (measured in Hertz, which is simply the number of times something happens in a second) and the algorithms that the processor is running, and more efficient algorithms might be able to perform a task using fewer instructions per second than a less-efficient algorithm (QUIK believes its algorithms are proving to be some of the more efficient algorithms for many sensor tasks). But, for an algorithm that requires one million instructions per second, or “1 MIPS,” the QUIK S2 LP sensor processor would use a little over 150 microwatts, while the M4 would use over 200 microwatts. The chart shown below compares the power consumption of the QUIK S2 LP to the ATML M4F for duty cycles up to 1 MIPS (these charts are available on the company’s IR page under “financial events” from the earnings call and presentation for the quarter ending March 2015):

While the S2 LP has a lower power-consumption profile, the M4F can basically handle these tasks within the power envelope of most smartphone batteries today without breaking the power budge of 1% to 2% of the total battery charge that OEMs have said they can tolerate being depleted by a dedicated sensor processor. This fact explains why OEMs today can use microcontrollers such as the ATML M4F and satisfy the sensor data loads they need to process within their existing power budgets.

However, more demanding “always aware” applications in future devices with more sensors sampling more frequently and running more algorithms (such as those monitoring your sleep patterns all night, or performing indoor navigation functions) will place higher demands on the sensor processing platforms, and QUIK believes that this is where the QUIK advantages will really begin to show versus competing approaches. The chart below picks up where the above chart leaves off – and looks at duty loads above 1 MIPS:

This chart projects the power consumption when using the QUIK next-generation sensor processing solution platform, dubbed the S3 and due for release later this year (“mid-2015,” for what that is worth). Clearly, if these projections are accurate, the differences in power uses will be so significant for more-demanding sensor-processing tasks that the S3 will be the clear choice for designers.  At 55 MIPS in the chart above, the S3 is using only 1.65 milliwatts, while the M4F is using somewhere above 10 milliwatts. Put another way, at 55 MIPS, the S3 can operate at a level of power consumption that the M4F hits at only 8 MIPS.

Again, it bears repeating that QUIK’s solution provides not only significant hardware-based advantages as a result of their unique architectural approach, but also a range of very efficient sensor-oriented algorithms, including some of those listed in the blue squares along the lower edge of the chart above, as part of their “SenseMe” library of algorithms.

Current customers:
Although it should be emphasized that the entire market for the kinds of sensor-rich, context-aware applications that these solutions are designed to enable for OEMs is still very much in its infancy, there are reasons to believe based on what QUIK has revealed so far that customers are extremely interested in the capabilities described above and that they are actively engaged in the evaluation stage on QUIK’s S2 product, with some of them lining up to evaluate the S3 as soon as it begins to roll off the fabs as well.

QUIK has three customers announced in the conference call from the December 2014 quarter who are using the S2 in a sensor-hub capacity in wearable products: one of them an eye-mounted device (from a company in Japan called Telepathy, on a product called the Jumper), and two of them wrist-mounted (one of them from FoxConn, on a product which we believe will be marketed in China, possibly for children to wear to enable them to communicate with their parents or enable parents to see their location, and one of them from a yet-to-be-named OEM). In the most-recent call for the March 2015 quarter, QUIK revealed that these companies all delayed their production for reasons unrelated to the sensor processing solution, although it appears that FoxConn did express interest in a new algorithm that QUIK is developing to add to their SenseMe library. Whatever the ultimate level of success these initial OEM customers have with these particular products, we believe these are likely just the very first little lapping waves on the shore of a trend in sensor processing products and requirements that will soon become a flood tide. Additionally, QUIK announced in the earnings call for the March 2015 quarter that these three customers have been joined by two more who are using the S2 in a sensor processing capacity and who are taking production-volume shipments in the current quarter (the quarter ending at the end of June 2015).

At the same time that these initial S2 customers are beginning to take production-level shipments from QUIK, other potential customers are engaged in various levels of evaluation of the S2. At the end of last quarter (ended December 2014), the company announced that engagements had jumped from around eight to almost two dozen, and during the most-recent quarter’s earnings call (for the quarter ended March 2015) the company revealed that this two dozen number has now nearly doubled, implying a very robust “pipeline” of potential future designs that could incorporate the S2 (close to fifty, in other words, and probably above 45 engagements).

Additionally, the company is offering an “alpha” program for its S3, which is something we have not seen from QUIK before on previous products. In this program, a potential customer who wants to evaluate the S3 would be sent versions (“rough drafts,” so to speak, for them to “proofread”) of the new product almost as soon as the QUIK engineers receive them from the fabs. They would receive these early runs with the understanding that some bugs still need to be worked out, but they would have the opportunity to use these QUIK products as part of their own design and evaluation on the way to possible incorporation in a smartphone or wearable or other mobile product. In order to be in the alpha program, a potential customer must have executive sponsorship (indication of interest in the S3 from the executive management, the customer must be a “top-tier device OEM” (such as LG, or Lenovo/Moto, or HTC, or XiaoMei, for example), they must have a specific funded project for which the S3 is being evaluated, and they must agree to a formal feedback process with QUIK as they receive and evaluate these S3 runs (QUIK engineers, of course, would be checking out the early products at the same time as they roll out of the fab). QUIK stated that they have one top-tier OEM in the program now, with a second in the engagement process as another potential participant in the alpha program.

Obviously, we do not anticipate S3 revenues from production-volume shipments to begin until some months after the first S3 products are released later this year – and thus probably not until calendar-year 2016. However, despite the company’s conservative guidance for the current quarter (at a guide of only $5.5 million in revenues, less than the quarter they just reported, this projection does not incorporate major volumes of S2 shipments this quarter either), we do believe that S2 shipment volumes will increase later this year, although the timing is dependent upon OEM customer business decisions and of course on the success of their various products.

We believe that the bigger point is that the market for wearables, and for all kinds of mobile devices including smartphones, containing sensors with more robust and more context-aware higher-MIPS algorithms is only in its very early stages, and that it is very likely that processing demands will increase dramatically in future months and certainly in future years. While the company only has five products shipping early stages of production volumes of the S2 this quarter, it is not unlikely that we could see ten to twenty products within just a quarter or two.  When (and if) a major smartphone OEM incorporates the first S2 or S3 in a flagship smartphone, we could see tens of millions of such devices shipping in a fairly short period of time (perhaps by a year or two from today). 

The company ended the most-recently-reported quarter with $28.2 million in cash, and $34.3 million in current assets.  Even at the low quarterly revenues of around $6 million, the quarter’s net loss was about $3.6 million – which means that at around $11 million in revenues the company would start to be profitable (perhaps a bit higher, as expenses would of course increase to meet higher volumes of production and to field higher numbers of sales and support personnel).  At this time we do not believe an additional capital raise to “keep the lights on” is likely to be necessary in the quarters between now and the time that revenue increases should materialize.

However, we realize that the Street right now does not care very much about all of the charts and predictions just described: they care about revenues and about one quarter of guidance. We believe this creates an opportunity for investors with longer time horizons (we generally measure our investment horizon for growth companies in terms of years rather than months or even quarters, especially for smaller growth companies such as QuickLogic).

Potential concerns:
Of course, as Benjamin Franklin famously admonished, “there’s many a slip, ‘twixt the cup and the lip,” meaning that all of these potentially lucrative markets and projections are still “in the cup” and there are potential pitfalls before they can be realized.

We will address just a few of the most important concerns investors must consider.

  • Alternative solutions: the discussion above shows the significant potential advantages QUIK is bringing to the market. However, technology investors know that creative people can come up with other ways of solving problems, and there have been instances where the “best” technology did not in fact win out in the marketplace. Some argue that apps processors will be able to absorb the role that dedicated sensor data processors are filling today, although we believe there are several reasons that the direction AP designs are going will make them even less likely to be able to handle sensor processing and “always aware” functionality than they are today. 
  • Smart sensors: of greater concern perhaps is the idea of the “smart sensor,” or the incorporation of “sensor hub” functionality into a ubiquitous sensor such as the accelerometer (accelerometers are now present on virtually every smartphone and will probably be found on most wearables). Why would OEMs want to buy a separate sensor hub if they can get similar functionality from a “smart sensor”? This is a legitimate question, and we believe some OEMs may go this route for some devices. The fact is, however, that the potential market is likely to be very big, and very diverse, and while this solution may be appropriate for some devices, that does not mean that it will prevail in all cases, or even in most cases. We believe that it may not be attractive to most OEMs because there are several sensor companies out there, and OEMs like to have them competing for slots in the OEM’s products, so that the OEM can have multiple suppliers competing against one another and multiple suppliers from which to choose (rather than getting locked-in by one sensor provider).  Sensors may be somewhat commoditized, and sensor companies would like to get out of that category, and so of course they like to promote the “smart sensor” approach, but going this route could lock the OEM in to one sensor provider not just for current products but – as we have touched upon – for their “future roadmap.” This is a serious counter-argument to the “smart sensor” approach, in our view. Again, we believe it may be used for some portion of the market, but that the QUIK solution is not unduly threatened by this possibility.
  • Other programmable companies: Of the other makers of programmable logic, Lattice (LSCC) has been the most focused on addressing the needs of the mobile market, but they have focused more on the types of “workaround” applications that programmable processors have historically been good at solving for “shorter-term” product designs. At this time, we believe the QUIK distinctions in terms of their PSB approach, their specific architectural decisions to maximize power efficiency even at higher duty cycles, and their “complete solution” approach of developing a library of in-house algorithms provide QUIK with clear differentiation at this time. 
  • Major unforeseen battery improvements, or battery-charging improvements, such as the ability to simply charge the battery all the time wirelessly wherever you are.  So far this is not a serious concern, but it could become a concern in the future.
  • An inability by the company to handle large orders when they do begin to arrive. We believe the team is experienced, solid, and competent. They have been through the vetting process at Samsung and have had Samsung as a customer for years now. We believe that large orders will be a “good problem to have” and that QUIK will be able to handle those orders with their fabless model when those orders begin arriving. Nevertheless, this is always a good concern but one of which investors should be aware. A failure to ship product to a major OEM can ruin a company’s reputation very rapidly, and we have seen it happen to small companies that take years to recover or which in some cases never really recover at all.
  • A major reversal in the use of sensors, or a rejection of sensor functionality by the public. 
  • A failure for the increase in sensor data sufficient to demand duty cycle loads requiring more power-efficient sensor data processing. The QUIK sensor processing solutions become more attractive at higher duty cycles, and at this time may be the only possible solution for duty cycles above some threshold between 25 MIPS and 50 MIPS. However, if data processing requirements never reach those thresholds, the advantages of QUIK’s power efficiency are still quite significant, although less dramatic than at higher duty cycle levels. If sensor data loads never approach those levels, it would impact the investment thesis. However, we believe this possibility is very unlikely. The reader can conduct his or her own research on the potential market for wearables, and can consider the types of competition already present in the smartphone market and the desire for OEMs to be able to offer features that differentiate their products and help their phones impress potential buyers.  Some have noted that the “internet of things” can in many ways be thought of as an “internet of sensors,” so central will sensors be to the types of tasks that wearables and other low-power, mobile and connected devices being dreamed about, designed, and developed right now. And, while we believe the Street has yet to truly realize it in any meaningful way, we believe that virtual reality or VR has the potential to be truly transformative for a wide variety of visual media, education, entertainment, gaming, and sports broadcasting. VR devices such as the Samsung VR will require additional sensors and additional sensor data processing. In short, while the forecasts for the types of new devices and new requirements that are discussed above are still very tentative, it is very likely that this market will grow exponentially over the next few years.
  • Arguments that the management team is not competent. Some bearish pieces, at least one of them from a short-seller of the stock,  have made this argument. We believe that not only is it incorrect, it is backwards. In our assessment, CEO Andy Pease arrived at QUIK in 2006, became CEO in 2011, and made strategic decisions regarding the company’s specific strengths, and regarding the  new markets where QUIK’s specific strengths could offer the greatest value. The decision to target the incipient sensor data processing needs of mobile OEMs and engineers we believe to be frankly a brilliant application of QUIK’s unique strengths to an area where OEMs and engineers are facing two very real and very pressing dilemmas, both of which QUIK is uniquely positioned to solve. If the company had to use shorter-duration “connectivity” and “display-bridging” revenues as “stepping stones” to get them to the point where they are today, positioned in front of a nascent sensor data processing market that is just now in the beginning stages of opening up, then we believe that was an example of good management and good leadership.
  • The resignation of their CFO. We are sorry to see their CFO depart for a new opportunity, but in our opinion the CFO does not set the vision for the company. The CEO sets the vision and the CFO helps make it happen. We do not see any indication that the CFO’s departure had anything to do with an inability to make it happen, but rather that it had to do with an immediate offer from another company which he decided to accept for his own reasons that have to do with what is best for him. We do not believe that it will be difficult for QUIK to find a competent person to manage the company’s finances in a way that will support the current vision. We believe the current vision for the company is clear, that it is a valid strategy, and that the financial conditions in terms of cash flows are probably going to be sufficient to achieve it. The personality of one CFO versus another will not change that at this particular juncture, in our opinion.

We believe that the QUIK story is fairly complex and requires a rather involved level of market-specific knowledge, as well as familiarity with some specialized semiconductor architecture issues. The company is currently not widely or well understood, in our opinion. Investors have recently been seriously spooked by declines in revenues from products that were all along necessarily shorter-duration designs with OEMs, in bridging and connectivity applications. The real growth opportunity for this company, we believe, is in the sensor data processing market, which is still so early that it is impossible to predict with great detail, but which will almost certainly grow exponentially over the next two to seven years. Investors who understand this, however, have recently also been disappointed by the failure of the sensor market to immediately ramp, and have punished the stock accordingly. The ride in this stock over the past year has been extremely painful, as highs that were generated based on excitement over shorter-duration products evaporated rapidly and the stock has seen several sharp freefalls to successively lower lows since then. 

However, we believe that the sensor opportunity is still just getting underway, and that the company’s customer engagement numbers reveal a robust pipeline. In fact, the company is in the enviable position of sitting in front of a potentially tremendous market in consumer mobile devices (products with some of the highest potential volumes on the planet), at a time when it could be facing one of those fabled “paradigm shifts” which one reads about in business school or related literature, but which investors at times stop believing in. With a market valuation of just under $100 million including cash, and with cash on hand (at end of March 2015) of just over $28 million, QUIK is a company that is basically valued around $70 million – which may indeed be an incredible value, based on the potential markets just described and the potential advantages their solutions offer to OEMs. 

In many ways they are like a venture investment, which often price at valuations this low in their early investment rounds, on companies that still don’t even have revenues (QUIK is set to get at least $20 million a year) or breakeven potential for years into the future (QUIK might reach breakeven in a matter of a few quarters) or major customers (QUIK has had Samsung as a customer, and appears to have one if not two other top-tier OEMs considering their upcoming S3 product for evaluation). Like a venture investment, there are risks, but also like a venture investment, there are eye-opening possibilities to consider, especially at these valuations. And, unlike a venture investment, QUIK is a public company, filing financials with the SEC in accordance with GAAP, and trading on public exchanges where there is immediate liquidity for investors if they need it (unlike a venture investment which can require lock-in for years). Unlike a venture investment, QUIK is also available to any investor who wants to buy it – although of course we recommend using this report as only a starting point for your own evaluation and due diligence of the investment merits of the company. 

And finally, unlike many venture investments, QUIK is led by a seasoned management team with a board of experienced professionals who know the company, know each other, and know the markets (the board includes QuickLogic’s founder and other industry veterans).

Important Disclosure Information: 
At the time this report was submitted for publication, the principals and clients of Taylor Frigon Capital Management owned securities issued by QuickLogic (QUIK). Of all the other companies mentioned in the report, at the time of submission for publication, the principals and clients of Taylor Frigon Capital Management owned securities issued by Apple (AAPL) only, and none of the others.

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Taylor Frigon Capital Management LLC), or any non-investment related content, made reference to directly or indirectly in this research will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this research serves as the receipt of, or as a substitute for, personalized investment advice from Taylor Frigon Capital Management LLC.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Taylor Frigon Capital Management LLC is neither a law firm nor a certified public accounting firm and no portion of the research content should be construed as legal or accounting advice. A copy of the Taylor Frigon Capital Management LLC’s current written disclosure statement discussing our advisory services and fees is available for review upon request.
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