Beware tech companies that could go the way of the knocker-upper

By Roger Montgomery, Montgomery Investment Management

When it comes to investing in tech companies, it's essential to distinguish between two types of businesses. On the one hand are hardware companies, which can end up fighting for market share and, eventually, relevance. On the other are platform companies, which benefit no matter which technology ends up winning.

In Britain and Ireland back when alarm clocks were neither cheap nor reliable, and as recently as the 1950s, a knocker-up was a profession. Using a stick or a pea shooter, a knocker-up's job was to rouse sleeping people, by tapping on their window, so they could get to work on time.

Since then, a litany of new technology has emerged and subsequently been discarded rendering hardware, software, business models and even entire professions worthless. From cockpit-based flight engineers and vacuum incandescent bulbs, to VHS and Beta video, cassette tapes, CRT displays and floppy disk drives, DVDs and CDs, dial-up modems, PS/2, FireWire, RS-232 and their associated DB-25 connectors, as well taxi meters and dictaphones, a multitude of technology helped humankind for a time before becoming superseded or redundant.

A quick journey down memory lane, using global camera shipment data from the Camera & Imaging Products Association (CIPA) also reveals the accelerating pace of change. Over 65 years, between 1933 and 1998 analog camera sales rose from virtually zero to their peak of 40 million units. It took just six years for sales to slump to virtually zero as the appeal of compact digital and digital SLR cameras quickly broadened the market for cameras overall. By 2010 global sales of compact digital and digital SLR cameras exceeded 120 million units. But by 2016, just six years later, sales had slumped more than 80 per cent to 20 million units as smart phones drove another step change in convenience and global reach. By 2017 smart phone sales had exceeded 1.5 billion units, replacing a range of single-purpose devices.

It's difficult to imagine a world where smart phones are rendered redundant, but just as the alarm clock eventually became more reliable than the knocker-up, and was then itself replaced, it is almost a certainty that smart phones will eventually be redundant. And that brings us to the investment case for new technology.

Investors must first remember that obsolescence is a constant. But it is even more important, particularly at this point in the credit cycle - and amid the hype surrounding AI, AR, VR, 3D printing and autonomous and electric vehicles, to ask whether the investment case presented by a company delivering new technology is as attractive as the technology itself.

It is not uncommon for technology investors to be caught up in the very same euphoria that attracts consumers. But what is good for consumers is not always great for investors. In fact, history shows that billions of dollars of shareholders' funds can be destroyed as new technology first replaces the old and then expands globally as it's adopted broadly by its customers. Witness the great leap forward humanity took with the advent of commercial aviation, including the enablement of global supply chains, and yet in aggregate, 275 global airlines will generate a lower profit in 2018 than Apple did in 2016.

It's also possible to be caught up in success that isn't financial. Take Twitter, Snapchat and Uber; these are new technology companies with innovative business models that have rapidly become household names, if not verbs. Despite their ubiquity, however, they aren't making a profit.

It is further true that companies and their underlying businesses don't operate in vacuums, they are invariably subject to forces beyond their control - even the profitable ones. Whether it is social, technological, climatic, competitive or legislative, these forces represent change that is not only beyond the ability of company boards to respond to adroitly, but even beyond their ability to anticipate.

I like to think of change in business following the expansion and contraction of the bellows of a piano accordion. Expand the accordion: fragmentation. Contract the bellows: consolidation. Fragmentation, consolidation, fragmentation, repeat.

Most recently, data privacy scandals (Facebook) and the EU taxi strikes (Uber) demonstrated once again that power will continue to expand unless it is met by an opposite force. Societies disapprove of a concentration of influence or control and democratically elected governments must respond to societal demand or lose control themselves. With the EU adopting tough new data privacy laws and determining Uber is a taxi company, it is clear that investors who project indefinite growth in users, sales and earnings are adopting optimistic assumptions that history does not support. In fact, investors must factor in to their valuation all of these factors; inevitable technological obsolescence, competitive dynamics, societal and legislative backlash.

The automotive industry is one where all of the above forces have or will influence returns for shareholders and is therefore a reasonable example of what investors need to consider. From more than 800 US car manufacturers, only the Ford Motor Company, has survived to the present day without a bailout from the US government. That in itself speaks volumes about the challenges faced by a capital and technology-heavy industry making fashion statements with a relatively short shelf life.

Despite the state-sponsored largesse, and despite delivering six million vehicles last year, Ford remains riddled with debt, generates a profit that is only 22 per cent higher than that of thirty years ago and a dividend below that of twenty-five years ago.

A phalanx of manufacturers vie for the attention of consumers, each with a wide range of models customisable by the individual. Fashion, which is fickle, dictates everything from interiors to external colours and each company must adopt new technology as and when it emerges. Adding to the challenges are differing global standards on fuel and the inevitable shift, thanks to societal and environmental demands, to electric drive trains. Electric engines promise to reduce manufacturing costs and improve efficiencies, but every manufacturer will adopt the new standard leaving few with a competitive advantage and ensuring price is once again the driver of sales and the eroder of margins.

Even electric cars - and the lithium-ion battery upon which they are currently driven -will go the way of the knocker-up. For that reason, investors should be discerning, as we have been at the Montgomery Global Fund, separating hardware technology companies from the platform tech companies that benefit no matter which technology gains supremacy.

 

Roger Montgomery
Roger is the Founder and Chief Investment Officer of Montgomery Investment Management. Roger brings more than two decades of investment and financial market experience, knowledge and relationships to bear in his role as Chief Investment Officer. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

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