Tuesday, September 07, 2004
Don't confuse Internet stocks with tech stocks
Summary: Fund managers who misclassify Internet stocks as tech stocks will lose performance over the medium term, because companies that consume technology will outperform companies that supply technology.
Too many fund managers, when thinking about sector exposure, view Internet stocks as technology stocks. But they're not.
If you think this is obvious, remember that most sell-side equity research departments appointed technology analysts to cover Internet stocks in their early days. After all, Netscape was a software company and technology analysts were the ones who understood the Internet. Bear in mind also that investment TV shows, magazines, web sites and newsletters frequently group Internet stocks and technology stocks together.
And technology stocks and Internet stocks share many common traits: both are volatile, both appeal to retail investors and hedge funds, and both currently trade at insane valuations according to Fred Hickey (who indiscriminately lumps them together in the valuation discussions in his otherwise perceptive newsletter, The High-Tech Strategist).
But the casual categorization of Internet stocks as a subset of technology stocks by portfolio managers, analysts, and journalists is an error that will cost investors money. Here's why.
Technology companies (according to the accepted use of the phrase) are producers of technology, whereas Internet companies are consumers of technology. True, some Internet companies also produce technology for their own internal use. But technology is a cost-center for those companies, whereas technology is a profit-center for true technology companies.
Why does this distinction between producers and consumers of technology matter?
Most investors focus on the simplest relationship between producers and consumers: if the consumer has no budget, the producer won't sell anything. Ergo, if Internet companies do well, that's good news for technology companies.
However, there are other factors determining the correlation between technology producers and consumers. Sometimes technology producers enable their customers' businesses. (Remember how early e-commerce companies benefited directly from the robustness of Unix-based Sun servers.) In that case, the profitability of technology producers is positively correlated with the profitability of technology consumers, with the direction of causation going from the producers to the consumers. But it's also possible that the profitability of technology producers is inversely correlated with the profitability of technology consumers. The more pricing power the technology producer has, for example, the heavier the expenses and the lower the profitability of the technology consumer.
Which of those possibilities best describes the relationship between technology producers and consumers over the next few years? I think the latter, where the profitability of technology producers and consumers are inversely correlated.
Here's why. New technologies in the early stages of deployment today are deflationary and will lead to shrinkage (at least in the medium-run) of aggregate revenues for the technology industry. To name a few:
- growth of free or cheap open-source software (pressures software prices and reduces revenue);
- commoditization of server hardware through standardization on Intel-based processors (reduces server prices);
- introduction of blade servers (which share, and thus reduce demand for common hardware);
- introduction of blade PCs (ditto);
- virtualization of processing and storage (reduces demand for storage and processing hardware);
- growth of "utility computing" (reduces demand for everything, particularly by smaller companies);
- outsourcing of software development and IT services to India and other low cost countries (reduces software prices);
- outsourcing of hardware manufacturing to China, and entry of low-cost Chinese producers into key technology markets (cell phones, networking gear).
All this is bad news for the technology industry in the near-term, and probably for technology stocks. While technology stocks may rise further as spending on IT recovers with the economy sometime (hopefully) over the next twelve months, these deflationary trends will subsequently kick in, depressing the revenues of technology companies. Later still, the step decrease in effective technology pricing should stimulate more demand for technology. But who knows when "later still" is? In the short-term, the technology industry faces potentially severe price deflation and revenue erosion.
Now the key point: price deflation, while painful for producers of technology, is great news for consumers of technology. Falling IT prices should extend the advantage of technology-consuming companies over their human-capital-intensive rivals. Technology deflation, combined with the rising cost of healthcare and the relatively high price of real estate will make it increasingly difficult for location-based, people-intensive businesses to compete with their Internet-based, technology-intensive rivals.
Many portfolio managers and analysts accept that technology revenue growth could be muted for the next few years, and are avoiding all technology-related stocks. But by categorizing Internet stocks as a subset of technology stocks and discussing the two in the same breath, they lose sight of the fact that Internet companies are clear beneficiaries of technology deflation.
The 2003 market rally lifted technology and Internet stocks together, but in 2004 we're already seeing a divergence between the two. Over the next few years, the two should de-couple further.
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