I’m writing you today from gorgeous Stowe, Vermont. What on earth am I doing in Vermont? Well…that’s a bit of a mystery for now, but I am excited to reveal the details to you soon!

Since I’m in lovely Stowe, however, and since the Casey Research offices just happen to be here, too, I thought I’d sit down with Alex Daley for a bit and pick his brain on technology stocks (his specialty).

Now Alex is a very smart guy. Far smarter than I am. Honestly.

How do I know this?

Because Alex used to work for Microsoft…and yours truly, who graduated with her degree in Computer Science, had an interview with Microsoft upon graduation.

Now I like to think I’m no dummy myself (I had 8 interviews and 7 job offers with big high tech companies upon graduation…but then again those were the boom years and everyone was hiring, so perhaps I’m not so bright after all…)   🙂 but you’ll notice the discrepancy — there was one interview that I completely bombed.

And I do mean bombed…It was horrible — I simply sucked. It was terrible.

Guess which company that was?

Yep, that’s right…Microsoft!

Now in my defense, they asked me all kinds of weird questions, “Tell me Susan, how much does all the ice in a hockey rink weigh?” (???) and I of course, not being that smart, had no idea.

None. I thought the interviewer was from another planet. It was absolutely the worst interview of my entire life.

But Alex Daley aced his Microsoft interview!

And luckily, he’s also a really nice guy (not at all like my awful interviewer, whom I would still like to punch out to this day).

So I happily sat down for an hour or so this week with Alex to pick his brain on all things technology, and I hope you enjoy our interview!

I wanted to know…

Why technology stocks? Why stocks at all? Why now? How do you properly evaluate early / mid / late-stage tech companies? How much of your portfolio should you dedicate to tech stocks? How did Alex get started investing himself?

(Nosy, nosy, nosy, that’s me…)   🙂

So today I bring you Part 1 of our interview, and I hope you enjoy it!

KFG:

So Alex, how did you get started in investing? What was your first investment ever and what did you learn from it?

Alex:

My first investment ever was a mock investment. My interest in investment got sparked as a kid, in pre-algebra class in junior high school, when we had to pick a stock, and everyone picked Coca-cola, Nike, and their favorite stocks at the time, and I found Berkshire-Hathaway, picked it, and won hands down in the class in the one-year investment performance.

But in all seriousness, my first real world stock with money on the line… I was a young kid and worked as a freelance programmer through high school and college, and I was a college professor at 19 years old, and was making money early in my life, and I decided to dabble in the stock market, which just about everybody was doing at the time.

I invested in all kinds of different companies, many of which went completely belly-up, and I got my first hard lesson in investing by dabbling in the market. At some level, I was luckier than most investors…many people started out in the stock market through their 401k, and sat through maybe ten years of bull market and got no hard lessons.

Me, I made the worst choices first and swore myself off of stocks and said, “I’m never going to do this again!”

But as my career developed, I began spending a lot of time with investors and venture capitalists in particular. My penchant for technology made me a very valuable resource, especially in the early days of the dot-com boom.

I spent a lot of time consulting with venture capitalists and angel investors on the technology behind the investments they were making, and I got known as a skeptic on business models, and whether people would really buy a piece of technology, and whether it was interesting, etc.

In exchange, I got a free lesson, many years of investing lessons, from some of the most successful people in the sphere, and that was very helpful.

So when I came back to public investing, it was right at the end of the dot-com bubble. That’s when I decided to get back in and really start heavily investing.

KFG:

So was this after it had already crashed?

Alex:

Yes it was…in fact, it was the crash that made me interested in investing again, because suddenly, things started to look cheap, and they started to look the way all of the investors had told me they should look, because they said,

“Look for where you either have a strategic advantage over other investors, you have more information, earlier access to deal flow, better understanding of an industry…some advantage over the next guy who’s going to buy a stock, so that you can be there first.”

And that basically was not possible during the dot-com bubble, but when investors ran scared away from technology, suddenly you could have the information advantage again in tech stocks.

So I started dipping in again with all this new knowledge, how to invest, how to think about companies and long-term growth, and I started focusing back on the market, and my focus ever since has been on companies with really good growth potential.

It’s one thing to invest in a company that has traditional Graham-Dodd value investing principles, “oh, its P/E ratio is 7”…chances are, 9000 computer models and 3000 dedicated professional traders figured that out 2 seconds after it happened and long before you stumbled onto it on Yahoo! Finance.

KFG: (laughs)

Alex:

You can’t have an advantage in value investing—it’s dead, it’s over, it’s done. But you can understand the potential of a product or a market or a company better than somebody else. How much it really can go South. So that’s where I’ve always focused my energy…how much potential is there really?

And I’ve learned a lot of hard-fought lessons about not just the potential for technology, but the potential for the management of the company, and the potential for the economics of their business model…a lot of different considerations have to come into play.

Ultimately, when you’re investing in technology, frankly the only advantage that any of us can have in stocks nowadays, is understanding the future potential better than the other current investors of the company.

If you can do that, you can be a very successful investor, which is what I’ve done for myself and my subscribers.

KFG:

So in order to do that, do you need to be a technology expert then, to get that advantage and to understand the potential?

Alex:

I don’t think you need to be a technology expert, per se…one doesn’t need to know how an iPad’s silicon works in order to know that an iPad is going to sell very well. We need to be good observers of businesses and their patterns of spending and of consumers and their patterns of spending, but you do at some level have to have someone or somewhere to turn to make sure that the technology is good.

There are a lot of great-sounding technologies that don’t end up working well in practice.

KFG:

So how do you sort those out? I mean, I realize that’s why people pay you, to do this for them, but how do you go about doing that for your subscribers?

Alex:

We start with research. We start with academic research. We look at companies, especially in the biomedical, pharmaceutical space, and in order to participate in that space, you have to publicly produce research, and it has to be peer-reviewed, and it has to go through the FDA approval process, and it’s highly transparent, but it’s also filled with hundreds and hundreds of pages of technobabble that most people can’t understand, which means that we can apply the principle of having an information advantage.

As experienced technologists, we understand it well, but as people who’ve spent our careers in technology, we also have access to a large number of people who can help us sort through that data, so we rely on our network of colleagues throughout technology to bounce the technology off of and see if it works and see if it makes sense. So once we know that the technology works, we look at the market, and look at what’s the potential and how much could it sell.

We look first at the technology, and we look at it ourselves. We have our extensive long-term industry contact list to rely on if there’s something that’s beyond our scope or we need something for somebody to train us on plus interpret.

And beyond that, we look at the market, we look at the size of the market, how many potential buyers are there for us, what’s the likelihood that the company can break into that market, how many competitors are there, etc.

I’ll give you an example of a biotech company because I think it makes the cleanest example of growth companies and the importance of looking at the market as well as the technology.

So a biotech company that has a drug targeted for Hepatitis C, for instance, they might be facing as many as 27 Hep C cures at some level of clinical development in the FDA pipeline, not to mention the ones in the lab, it’s a huge market, and there are a lot of big companies with deep pockets going after it, so even if you are successful, chances are that you are going to face a lot of competition, and a lot of very big competitors who can price you out of the market, which means the potential for the drug might be a lot lower than it seems at first blush.

On the flip side, if they are going after an orphan disease for which there are no other treatments, they may be the first to market, they may have a long-term market all to themselves in which case they have a lot of pricing power, a captive audience, and you will be able to capture a very large percentage of it, so even if it’s a much smaller market, it may have much higher gross revenues for the company, or at least much higher profitability, and profitability is ultimately what matters.

And the same thing applies in any other form of technology of course, whether you are selling consumer electronics or software, your ability to market it to the market effectively…the size of that market matters.

We look at lots of niche business software providers; we look at companies like Pegasystems, and BEA Systems, who have great products but who have struggled to bring them to a wide audience against competitors like Oracle and SAP and Microsoft.

A big part of this is also the management team, looking for a team that’s been successful in bringing products to the market before, and if you’re looking at a biotech company, hopefully you’ll find members of the board and executive team who have 20 – 30 years of experience in that industry doing new product development for a very long time, and know what it really takes from a developing side and an interesting side, to successfully launch a profitable product.

So it’s a three-part equation…

  1. Is the technology great? That alone is not enough, but it’s a requirement.
  2. Does the economics and business model make sense…? Do they have a good product at a good price in a relatively low-competition space.
  3. Management team

Look at a product like the iPad, there was no competition, nobody had anything quite like it on the market, there really were no other tablets, it was a great product and a great technology and it was priced incredibly aggressively in order to keep competitors out of the market as long as possible. They were able to effectively buy themselves a two-year head start over everybody else, and make a great profit in the process by charging a price that still, despite being very aggressive, left 20 – 30% net profit margins for the company, which is typical for Apple.

So you’re looking for that combination of great technology, great business model, and a great management team.

KFG:

You mentioned P/E earlier…what about financial statements? Do you look at financial statements, and if so, what are you looking for if P/E isn’t enough?

Alex:

Yes, we do look at financial statements in-depth, they are very important tool, even though some of the traditional metrics of value investing aren’t what we’re looking at. We are looking at financial statements and we are looking for different things depending on the development stage of the company.

Pre-Revenue Companies
A pre-revenue company, such as a biotech company that’s exploring a new market, or a software company that’s in start-up mode, we’re looking mainly at things like how much cash does the company have available and how fast are they burning through it—that tells us how likely we are to be diluted as shareholders…to have the company out raising more money and ultimately lowering our slice of the pie and decreasing the value of our shares.

If you see a company that has only enough cash to last six months, and it’s going to be two years reasonably before they bring their product to market, chances are you’re not going to want to invest yet, you’re going to want to wait until a later round in order to invest, or you’re going to want some protection against dilution in the way they raise money.

So that’s your early stage, but now if you’re dealing with a company that’s already generating revenues, but isn’t quite profitable, what you’re looking to understand with that company is at what point is it going to become profitable and how much will the company be worth when it does, because profits ultimately are what matter.

When you buy an early stage development company you’re ultimately planning to sell those shares to another investor, probably to someone on Wall St., or an institutional investor like an insurance company or a pension fund, who’s looking for larger stable companies with predictable cash flows …these are the kind of things they are looking to buy.

And you are willing to take more risk for them, buy it early on, finance the company’s growth, and sell later to them.

Mid-Stage Companies
So if you’re looking at a mid-stage company, you’re really trying to understand if they are continuing to accelerate the growth of their revenues, or are their costs coming in faster than the revenue growth? A lot of companies will make big common execution mistakes—one of them is growth at any cost.

Companies that are willing to spend $200 to bring in the next $100 of revenue are dangerous…what you’re looking for are companies who have sustainable revenue growth that will get them across the threshold of profitability and allow them to grow earnings over time.

Many companies in the CET portfolio have been in that stage.

We invested in a company called Next Stage Medical that was in the process of reforming their business from running kidney dialysis centers to selling an at-home kidney dialysis machine that was cheaper, more effective, better quality of life.

It was great technology, and the business model was a lot better, all of the metrics of the business were improving, but for any other management team, it would have been a very difficult transition to make, to transform that company.

But they were able to sustainably migrate their business to the point where now they make more than 50% of their revenues off of those new machines, and they are now profitable. It took them three years of transition to get there, but they got there, and the result has been great gains for shareholders.

Big, Profitable Companies
And what we’re looking for when we’re looking at that big, profitable company is those same kind of metrics about profitability and margins.

Some of the red flags we’re looking for are companies who are growing at any cost, and that shows up in decreasing gross margins, decreasing net margins, decreasing profitability, increased debt.

Take a look at a company like Hewlett-Packard. Hewlett-Packard by all extents has been growing its revenue over the last five years, however you’ve seen their share price plummet in that period of time and the reason why is they’ve greatly increased their long-term debt in order to finance that growth.

So the company has been leveraging themselves to grow at basically any cost, and the result has been ultimately a lower quality of earnings and a much-deteriorating balance sheet.

Whereas on the flip side, you see a company like Amazon.com. Amazon.com has been focused on the strategy of moving itself to become not just a physical goods supplier, but also the digital goods supplier of record. They sell videos on demand, mp3 music downloads, and of course most notably Kindle books.

The result is that each product they sell in the digital world requires significantly less labor and less infrastructure to sell compared to a physical widget that has to be stored in a warehouse and shipped across the country.

The result has been that Amazon has seen steadily improving gross margins and net margins and as the digital economy takes hold we expect that trend to continue.

So Amazon has been lucky enough to both grow its revenue but also to grow its profitability faster. As they continue to staff up they’ve seen ups and downs in that, but I think the long-term trend over the next five years is going to be a much more profitable Amazon than the world has known before, because digital goods simply scale a lot more effectively.

KFG:

So how long would you typically hold a technology stock? What timeframe are you looking for and what type of exit strategy do you use?

Alex:

We typically look for investments on a minimum horizon of about 12 months. We’re not looking for arbitrage opportunities. We’re not traders out there trying to exploit whether this is stock oversold today and will it be worth more next week.

What we’re looking for are companies that are going to deliver value to shareholders in terms of real, concrete growth of revenues and earnings, because we believe those provide us with the highest chance of having a stock that is legitimately more valuable tomorrow than it is today.

So we’re investors, we’re not traders, we’re not arbitrage or short-term.

So what we look for is minimum about 12 months, sometimes as long as five years, and it highly depends on the company and the return portfolio.

What we do is we specify for our investors in our service what our price targets are for a company based on future profitability, as well as the time horizon we reasonably expect the company to get there in.

Sometimes they come in a lot faster than we expect. In late 2011 we were early in the robotics sphere, but a lot of investors followed our research and followed us into that market, pushing up values over the course of 6 months to levels we didn’t expect to see for 18 months.

In those types of cases, we’re also not afraid to get out of a sector when we see it as overvalued. If we see a stock that is moving in the wrong direction, whether it’s dropping and we think it should be rising, or it’s risen too fast for reasonable valuations, we’re either going to cut our losses or take our profits earlier than expected.

So we’re smart about the way we manage our investments, but we’re not trying to become day traders.

The typical portfolio investment in Extraordinary Technology is about a 2-3 year horizon. They are usually these development stage or pre-earnings companies that are going to take a couple of years to realize their potential but when they do they become largely profitable.

KFG:

Where do you see technology today? Is now a “good time” to buy technology stocks?

Alex:

I think there are two different kinds of markets out there. There are markets that are favorable to the index investor, where effectively everything is going to go up at a relatively sane pace, and you can follow that advice of “buy all biotech”, “buy all semiconductors”, “buy all materials stocks”, “buy all consumer packaged goods”, etc.

Index investors do well in those types of markets. Early 2009 – late 2011 was a pretty good market for the index investor. However, stocks have gotten very valuable on a relative basis. If you look at traditional measures of stock market valuation such as the price to earnings ratio of large cap indexes like the S&P 500, stocks are at a pretty rich valuation today.

These are markets where I think a stock picker has a distinctive advantage over an indexer, and I think focusing especially on small cap and mid cap growth companies in this type of horizon has historically been proven to be a better strategy, and stock picker’s markets are excellent for people who are willing to put in the research and find the companies who three years from now are going to have a very significant growth profile.

So whether the stock market is at a 13 P/E ratio or a 17 P/E ratio, isn’t really going to matter, because the earnings of your company are going to be so much higher and your stock will be worth more at a low valuation or a high valuation in the future, so you’re not really worried about where the index is going as a stock picker.

And I think that this is one of those markets, today, that lends itself very well to that kind of strategy.

KFG:

So, why invest in technology instead of (or in addition to) other areas?

Alex:

Technology is important for most investors because it is the number one component outside of financials in almost every developed economy, every G8 economy in the world, whether you’re talking about the U.S., or Germany, or France, or England, etc.

Technology is the number one market. It’s also the fastest-growing component of the economy in almost every developing nation of merit, in Russia, in China, in India…technology is number one.

In many of the Pacific Tiger countries that we traditionally think of as manufacturing hubs, as textile hubs, the fastest-growing part of the economy is technology as well.

And that’s a natural result of the increasing middle class around the world. People out there are demanding everything from connectivity to the Internet, and there are now more smart phones than there are computers in the world, as well as looking for health care. There are more and more people every year in the world diagnosed with cancer, not because there’s more cancer in the world, but simply because more people are capable of being diagnosed.

Which means there is a larger consumer base and a larger demand for technology.

So everything from demographics of the world, to the consumer spending habits in the world, to simply the natural course of evolution of the economy from a goods-based economy to an information-based economy all supports the growth of technology.

So I think any investor who ignores it ignores the area of the global economy that is in the least amount of trouble and has the most potential upwards…you ignore that market at your peril.

So, I believe technology is critically important.

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That’s part one…I hope you enjoyed it! Let me know what you think about technology, biotech, and more in the comments…are you a tech investor?

Also, if you’re interested in Alex’s publication, it’s called Casey Extraordinary Technology (CET) and you can get a risk-free trial here. (That’s not an affiliate link, although I do subscribe myself and love it — I’m just a happy customer).

Thanks very much for reading, and I’ll see you tomorrow with part 2!

To your financial success,

— Kung Fu Girl