The Deipnosophist

Where the science of investing becomes an art of living

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Location: Summerlin, Nevada, United States

A private investor for 20+ years, I manage private portfolios and write about investing. You can read my market musings on three different sites: 1) The Deipnosophist, dedicated to teaching the market's processes and mechanics; 2) Investment Poetry, a subscription site dedicated to real time investment recommendations; and 3) Seeking Alpha, a combination of the other two sites with a mix of reprints from this site and all-original content. See you here, there, or the other site!

11 February 2008

Is it safe?

One reader chides me for purchasing stocks with high PEs, as though successful investing requires nothing more than a snapshot (frozen moments in time) of the opportunity rather than recognize that investing is a process and not an event.

Companies and their products have life cycles; so do stocks. Value stocks are nothing other than growth companies whose (rapid) growth is a thing of the past. Thus, value stocks represent opportunities largely for that class of investor fearful of the markets' continuing processes and trend -- its continuum -- and who prefer to hide under the covers of snapshot measures of a company's value and worth.

But investors never stay still for long; they seek always a company with increasing earnings (Why invest in a company that does not make more money at an increasing pace?) or a rising stock price (Why invest in a stock whose share price is declining? aka, to catch a falling safe.). So, while measures of fundamental valuation such as PEs are worthy, they remain insufficient. Investors express their interest in a company's growing fortunes via purchasing the shares of said company's stock; a rising share price manifests as one valid measure of interest on the part of investors, if other measures ratify that rising share price.

Oddly, there come moments when investors can purchase growth at value prices; these moments typically occur during and after market sell-offs, such as the market decline of the past ~3 months. Apple/AAPL and Google/GOOG represent two opportunities that I have publicly argued in favor of for a long while. Nothing is amiss fundamentally at either company; the market's decline merely served to lower these two companies' share prices and valuations to startlingly fine purchase points. And, yes, while the daily bar chart of each looks scary today, at least at first glance, things change. (Farther down this post I share a third opportunity.)

Another reader, Eric Chan, writes,
"With the market plummeting, are those market internals still showing a likely rebound in the near future? Perhaps that would help VMW on its breakout?"

The markets have since staged a bounce that, at this moment, appears likely to have legs, and which thus appears to be a fine opportunity for investors to buy during secondary tests. However, since Eric asked his question, VMWare/VMW broke down, and calamitously. The incessant fear regards the company's competition, especially from Microsoft/MSFT.

I have no doubt that VMWare's products will best whatever Microsoft offers as its solution to virtualization; Microsoft rarely offers a best of breed solution. But Microsoft is persistent and will invest for years to improve their offering, as virtualization is a key growth segment that is very close to their core markets.

More important, however, is the method by which Microsoft will compete in the near and medium term. Microsoft's strategic objective is...
1) To protect their core operating system and office spaces, and
2) To wound VMWare and impede it's growth, and
3) To make money in a new segment in that order.

Thus, Microsoft likely will deliver a minimalist offering that will appeal to the middle market. Almost no one in the Fortune 1000 will give it serious consideration, but mid-size companies will. Most important, they will sell it at a radically cheaper price. They do this primarily to spoil the market for the high-end, high-quality solution and slowly turn it into price-based market and could force VMWare ever farther up-market.

Simultaneously Microsoft will work to make virtualization more and more of a feature provided by their operating system. The list of stand-alone applications that became integrated into the OS is quite lengthy, and the landscape is littered with the corpses of companies who produced successful niche products that identified a segment for Microsoft and which Microsoft then destroyed by incorporating the feature into its OS.

I don't dispute for a moment the characterization of the situation today. And while I think I have a handle on how this thing eventually plays out, I have little in the way of insight as to how long this process takes. Probably it takes long enough that VMWare will have a good earnings trajectory for many more years. That seems the key question, if one is evaluating investing in VMWare: How quickly will Microsoft spoil their market? The answer: It will take more than a first offering but it will take less than a truly superior product.

Two methods (technology company) investors utilize to manage the risk of increasing competition is to find companies that:
1) Manifest as a first-mover, and thus have an increasingly impenatrable 'lock' on the market, or
2) Its products have patent protection, which places a wide and deep moat and castle walls around its product.

One technology company with
substantial patent protection, and which is familiar to many of this site's readers, is Qualcomm/QCOM. Qualcomm is, quite simply, the owner of CDMA technology; although, in addition, a chip designer that sells proprietary chips incorporating CDMA technology, though it contracts the actual manufacture of those chips. The CDMA technology benefits Qualcomm primarily through the collection of royalties on the use of that technology. The chip business benefits Qualcomm by the selling of the chips and chip designs they create and manufacture.

In a (very small) nutshell that is the whole company but as you might expect there is much more to the story. To evaluate the company one must begin by understanding CDMA and its value. CDMA is one of the two basic technologies that enable the cell phone. The other is various variants of TDMA. CDMA is an acronym for Code Division Multiple Access, TDMA an acronym for Time Division Multiple Access. There are other schemes as well, but they have largely disappeared.

Let's say you and I are both talking on our cell phones, but not to each other. We do happen to be standing very near one another, and therefore controlled by the same cell tower. Since we both share the same spectrum the cell phone must understand which incoming signal is meant for you and which for me. Likewise, should we each speak at the same time, the cell phone head-end equipment (on the tower) must be able to know which signal is coming from me so it can route it to the person to whom I'm talking. Since spectrum is an extremely scarce resource this (multiplied many times over) is the fundamental problem of all cell phone technologies.

TDMA solves the problem simply but inefficiently. Basically it "time slices" the spectrum. For a brief period, my conversation is "on", for the next slice I am "off" and you are "on". Since these time slices are faster than human perception we both see our conversations as happening at the same time. Of course, the more people accessing that tower on that spectrum at the same time, the more time slices are needed. At a certain point, no more conversations can take place off that tower at that time, and others trying to make or receive calls will be unable to do so until someone ends their conversation.

CDMA solves the problem in a fundamentally different way, one that, with the exception of a few diehards, is recognized universally as better and more efficient. CDMA is a variant of "spread spectrum" technology. Rather than time slice the two conversations CDMA transmits both conversations simultaneously but relies on decoder chips inside each cell phone to figure out which part of that signal is meant for you and which is meant for me. Though it requires more programming complexity it turns out that this is a huge advantage over TDMA.

Being totally digital and not having to devote complicated circuitry to handle the time slice algorithms, CDMA cell phones typically draw less power resulting in longer time between charging and/or smaller phone batteries.

There are limits to how refined TDMA time slicing can be. If sufficient time is not given to each active conversation - whether or not any actual talking is taking place at that instant or not - users will sense the delays. We are extremely sensitive to such issues once they reach the threshold of perceptibility. CDMA deals with crowding by "degrading gracefully" a technical term which basically means that every conversation may suffer slightly in terms of audio quality but no time delays will be noted. At a certain point of course, no more degradation can be tolerated and CDMA too will max out until someone hangs up.

There are few limits to how sophisticated the decoding programming can get in CDMA, resulting in innovation cycles that can pack more bits into any unit of cell phone bandwidth. New algorithms can increase the use of silence to improve carrying capacity, as can their ability to work with lower and lower signal strengths.

Similarly, these factors can drive CDMA to require fewer towers and/or more conversations off a single tower, and can do so with simpler, lower power head-end equipment.

Last, and crucially, spread spectrum provides sufficient bandwidth to support reasonable data rates for the transmission of digital data which, of course, is the driving edge of what's happening in the cellular arena.

CDMA is a primary technology in the USA (being used primarily by Sprint and Verizon), parts of Asia, and parts of Latin America. Until recently, TDMA was used primarily in Europe under the GSM system, also by parts of Asia and Latin America. But with the adoption of 3G and the need carry increasing amounts of data, Europe and other GSM areas are increasingly moving to what's known as WCDMA. WCMDA is bascially an amalgam of both technologies but the incorporation of CDMA algorithms has led most European courts to rule in Qualcomm's favor regarding patent royalties on WCMDA.

On a technical level CDMA is one thing, but on a business level quite another. Qualcomm is an extremely controversial company, perceived as a newcomer and interloper by older, more established, and primarily European, companies. For years, they stubbornly refused to adopt CDMA while spending hundreds of millions trying to find ways to engineer around Qualcomm's patents. Whether WCDMA actually is a necessary technology or just a blatant attempt to engineer around Qualcomm's patents is a matter of much dispute. What is beyond dispute is that CDMA would have worked for 3G European networks and that - in the end - they have accomplished little in trying to engineer around paying royalties to Qualcomm. Another key market that has resisted Qualcomm is China, which - having a closed market - has both only allowed CDMA to be deployed by a relatively small provider and heavily invested in likewise circumventing Qualcomm's patents.

These are business issues for Qualcomm that have repeatedly affected the company. There has been extreme hostility to the very thought of cooperating with Qualcomm, with established companies feeling that their technology ought to be freely available. (The courts seemingly do not agree.) But Qualcomm is also often seen as overly "aggressive” having pushed for high royalties and refusing to allow potential partners some slack given their strong position, thus guaranteeing that potential partners would resent them and seek ways to circumvent them. The blame is difficult to establish, but there is no question that the extreme ill-will that dominates this area has and continues to have a negative impact on the company.

Nevertheless, CDMA royalties remain the crown jewels of Qualcomm's business and a major source, of very high margin revenue.

Qualcomm however also has a second business. They manufacture various chips that incorporate CDMA capabilities and often combine them with other features. It is important at the outset to understand that they do not actually manufacture the chips. They design them and contract with fabs such as Taiwan Semiconductor/TSM to manufacture the chips. This is a quite common manufacturing technique for chip companies and leads to higher margins, lower invested capital, but also somewhat less control of the manufacturing process. It is also important to understand that Qualcomm - in its chip business - operates like any number of other companies that manufacture chips containing CDMA technologies. Companies such as Texas Instruments/TXN and dozens of others can and do produce chips containing CDMA technologies under royalty bearing agreements with Qualcomm. Wisely, Qualcomm has chosen not to be a sole provider of such chips as that would have only exacerbated their perceived problems with handset and network providers.

Therefore, in this business, they are one company among many, albeit one that has several advantages in that they do not have to pay royalties and have a more intimate knowledge of CDMA and where it might be heading.

This leads to what is probably the most important growth related issue for Qualcomm. It is a battle for the guts of the cell phone. Just as Intel/INTC - which dominates the X86 industry - has expanded for years by adding more and more to their processor chip, chip sets and eventually mother boards, in an effort to lever their control of the processor into more revenue per PC, Qualcomm whose CMDA chips are the "processors" of the cell phone has sought to garner increased revenue per handset by incorporating other technologies into their chip sets. Thus, they have added chips that include MP3 players, GPS systems, WiFi, and many other capabilities. Here, as well, the company has demonstrated something of an ability to get into spats with other companies over patents as witnessed by the long and litigious conflict with Broadcom. Their success in grabbing more of the revenue represented by cell phone handsets and headend equipment will probably drive much of Qualcomm's growth in the future, especially considering that there may well be some market saturation issues regarding handset growth, at least in the developed and
BRIC countries.

Thus limns the potential business opportunity for Qualcomm, and how it manages to make the best, or worst, of it. How about its investors...? Qualcomm remains to this day a growth company whose stock is available today at an inexpensive price and cheap valuation; its current earnings peg its PE at a startlingly low 20! Factor in a growth rate of ~20% in revenues and net income, and investors find a company whose growth rate matches or exceeds its PE, a PEG of 1 or less. (This calculation ignores the intellectual property lawsuit with Nokia/NOK, and which Qualcomm appears to have the upper hand.) The basic question re Qualcomm remains whether its executives' always-present hubris ("Hey, we are Qualcomm, and we offer CDMA. Enough said!") will cause the company to snatch defeat from the jaws of victory.

The company's shares reflect this uncertainty...

[click on charts to enlarge]

Qualcomm/QCOM qualified easily as 1999's poster child for share price momentum and extreme valuation; the investor need only view the highlighted portion of the chart to see that. The subsequent 8 years have told a different tale, although the three-fold rise since July 2002 obviously offered a profitable entry. The question becomes whether the current chart foretells whether QCOM will recapture its lost glory as a market leader; a future I believe will come to be.

Consider, first, a crucial market perception by
Dorsey Wright (below)...

The Basic Principle of Chart Patterns
There is one principle that is basic to all stock charting: a stock will tend to continue in the same direction in which it is moving. Most chart reading is an attempt to determine as soon as possible what direction this is. Sometimes it is an attempt to predict the direction of a move, but this is most difficult and can be dangerous. Let us look at what actually happens before a stock rises or falls.

Typically, it will sell in a certain range for a relatively long period. We will assume that it is bouncing between 35 and 45. When it breaks out of this range, either up or down, the expectation is that it will make a considerable move. In retrospect this zone is termed an accumulation area if the price has gone up, and a distribution area if the price has gone down. These two terms are based on the assumption that the "smart-money" is accumulating a stock before it rises, and are distributing it before it falls. If the stock rises above the 35 to 45 range, it is expected to find support around the 45 level because investors who were tempted to buy the stock before its rise will recall this as being a favorable buy level. If it drops through the 35 level (violates support), the price is expected to fall substantially.

Let us suppose that the stock, after considerable fluctuation between 35 and 45, moves above this range. It is felt that the 35 level will provide support to a price decline, that 45 will be a demand area. Presumably, investors who felt they missed the stock when the price rose will be willing to buy their stock when it returns to this zone. Again, if the stock passes through the low end of this range, it should make a good downward move. Frequently, advocates of some technical method or other will get excited about a stock moving through a previous bottom or top. Such a breakthrough may be significant, but it is not necessarily so. The mere surpassing of a previous point is not important unless the breakout is from a clearly recognizable formation. Not only that but you must also note whether the stock is above or below an important trend line and also whether the relative strength is positive or negative.

And this market perception from Trader Vic, Victor Sperandeo (excellent information at the embedded link! - dmg), who discerned a bottoming process to be as easy as 123...
1) A market stops going down,
2) A down trend line is broken, and then
3) A successful retest to confirm.

Voilà, a 123 trend reversal. Note the chart of QCOM, below, but this time with trend lines included...

Qualcomm/QCOM builds a massive (mega) bottom; from its all time high at $100 in January 2000 to its July 2002 low. (Down a whopping 85%!) Even though one key trend line is not delineated (that would be "D"), investors can see readily that which Vic Sperandeo and Dorsey Wright seek -- a market in a discernible area pattern, and turning... up, into a 123 bottom, as QCOM shares slowly trade along the right (up-) side of its chart. (NB: channels AA, AB, and rising trend line C.) A price near $35 manifests as a low-risk opportunity to buy; upside breakouts lie at ~$43 and, crucially, at ~$54.

Markets, merchants, and merchandise

All measures of valuation, price, and trend are attempts to discern risk and opportunity. One item I always keep in mind is my role in the process of investing; stocks and markets do not abscond with my (portfolio) monies via some grand plan to steal from me. So as not to perceive myself a victim of random market oscillations, I perceive a set of three: markets, merchants, and merchandise. "Markets" are obvious: they provide a (continuing) venue for buyers and sellers to meet and haggle over price and value before exchanging money for goods. My role is as merchant; my merchandise the stocks I buy cheap today to sell dear later. Yes, I allow for interim oscillations between purchase and sale. The market is merely a venue, and not an intangible mechanism that sets prices; most investors allow the market to set their prices, whereas I set the prices for my wares (inflection points, or maximum points of risk and reward). The markets do not happen to me because I am the market, the market is me.

Okay, that bit of fractal analysis might seem confounding, perhaps daunting, and even foo-foo. Try this. Investors should always keep in mind timing, akin to real estate's mantra ("Location. Location. Location."). It is better to be in the wrong stock at the right time than the right stock at the wrong time. But for consistent success, and for the wind at your back, it is better always to be in the right stock at the right time.

And so we return full-circle to the original question, "Whether 'tis safe now to invest...?" And, although seemingly oblique, this post provides my answer. I invest in companies and their shares, not markets. While markets might create better opportunities via a combination of changing price and shifting time, they do not establish prices. We, you and I, do that.

Full Disclosure: Not long Qualcomm/QCOM, but will be soon.
-- David M Gordon / The Deipnosophist

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