The original article was written by Bryan Shealy.
If Benjamin Graham were alive today, would he buy a deep value technology stock? This may be a trick question - after all, Graham was known as an activist investor early in his career, but we are talking about tech stocks here.
To most value investors, the answer seems obvious: No. One of Graham’s greatest students, Warren Buffett, has a stance against investing in tech stocks. Most investors understand value investing through Buffett's teachings. Warren Buffet has stated, “ I don’t invest in what I don’t understand.” Technology stocks are out of the question then, as you would need to have advanced understanding of the underlying tech to quantify their value. Since many see Buffett's words as gospel, buying tech stocks as value investments seems hypocritical.
However, Benjamin Graham invested differently than Warren Buffett. While Buffett concentrated heavily on a handful of stocks of companies that he knew well, Graham diversified heavily on a number of different companies that met a basic investment checklist. So long as the company met the checklist, it would be conceivable that Graham would buy the stock.
When he was younger, Graham would also pressure management to do what was in the best interest of investors. So, the chance of having some great activist activity come into play would surely have crossed Graham's mind.
Tech stocks have a history of enormous prices, though. So, valuation is another strong concern about tech investing and may deter Ben Graham from buying tech stocks. The high PE’s, the growth multiples, and the intangible software would be a nightmare. Technology stocks are predominantly growth stocks. They are also extremely young stocks and Benjamin Graham favored companies that had been around for years, had low levels of debt and much lower PE ratios.
Netflix.... A Deep Value Technology Stock?
Take a look at Netflix, for example. Netflix is one of 2018’s most well known tech stocks. It’s a fast grower, and traded at an enormous valuation. It’s price climbed by over 50% over the prio year and it’s PE ratio was 228x. Let's take a look at one of Benjamin Graham’s checklist that might help shed some light on whether he would invest in Netflix.
Benjamin Graham developed his simple way strategy near the end of his lifetime. It had 3 rules:
- Buy Stocks that have an earnings yield twice the AAA bond yield or more
- Never buy stocks for more than 10x earnings; a PE of 7x is always allowed
- Make sure each stock has an equity to assets ratio of 50% or more.
According to this simple way strategy, you should never purchase a stock with a PE ratio greater than 10x earnings. This was to make sure that you always buy cheap stocks, and Netflix did not fall anywhere close to this. It also did not meet the AAA bond requirement which would be 14. You could have gotten that figure by doubling the then bond yield of 3.52 and dividing it into 100. This would give us the 14, still nowhere even close. Lastly, it needs to have an equity to assets of 50% or more or in simpler terms the current ratio should not fall below 2.0. At 1.81 Netflix missed this mark.
What Does A Deep Value Technology Stock Look Like?
However, not all technology stocks are created equal and there may yet bet some technology stocks Benjamin Graham might invest in. For example, there are two types of technology stocks: software and hardware. Two examples of hardware product companies might include Seagate or Western Digital. These companies are part of the tech sector but they produce a physical product. These types of companies also invest in factories and provide the materials software companies need to produce their products. Benjamin Graham would surely invest in these companies over a software company.
Western Digital is an interesting example of a tech company that showed resilience in the face of economic hardship. In 2012, the company ran into a business problem. It was a large producer of hard disk drives; however, a new technology was developed, known as the solid state drive, that began to ravage Western Digital’s profits. Western Digital was stuck with outdated technology, but the company had solid fundamentals with low levels of debt and past profits. Western digital at this time had a PE ratio of just 7x and a equity to assets ratio of more than 50%. Western Digital eventually solved its problem by buying a solid state drive competitor SanDisk in order to diversify. Benjamin Graham would have loved a stock like this, but would he really limit himself to just one type of deep value technology stock?
Benjamin Graham and Warren Buffett had one particular thing in common -- they both invested in a company called Geico. Geico is a company that relied on an intangible product, insurance. This product eventually was even heavily supported by software and Geico essentially an internet company! Geico possessed the proven ability to create a product that was affordable and innovative. Like Western Digital, software companies including Microsoft, Cisco and Oracle have shown great perseverance through rough times, with low stock prices in 2002.
Benjamin Graham was a bottom up investor, this simply means he would look at the company fundamentals and not consider the industry until later, if even then! Therefore he would not differentiate between technology stocks or even segments within technology stocks, like software and hardware. Hardware technology stocks and software companies can both have the qualities that Benjamin Graham looks for in an investment. Whether you follow Benjamin Graham's simple way strategy or popular net net strategy many technology stocks meet his criteria. You just have to diversify.
Clearly, Benjamin Graham would invest in a deep value technology stock if he were alive today. But, there remains a problem. Without an understanding of the underlying technology, how would he be able to evaluate the price?
Technology companies are notoriously difficult to value since the underlying software is either brand new or constantly improving and changing. As long as the software had a record of supplying profits it could be argued to have a contributed worth. Benjamin Graham didn't need this information though, all he needed to know is that it had contributed to profits in the past. If Graham could put together a basket of stocks trading below their net current asset value (NCAV) per share, he’d just buy the basket and let their sub-liquidation value drive returns. At this point, any value the software may have would be considered a bonus.
Are Deep Value Technology Stocks Actually Fiction?
Dasan, at the investment blog Trader Thoughts, cites two factors that seem to suggest against modelling technology stocks in a deep value framework: Technology Companies need huge piles of cash on their balance sheets and Successful tech stock investing is done when they are in good fortune not when they are cheap.
Technology companies are very R&D heavy and a lot of their free cash flow is pumped into further research to stay ahead of the competition. This requires them to keep a lot of cash on hand that is not producing value or providing a good return on investment (ROI). They also need large amounts of cash in order to fund acquisitions to stay ahead of the curve. These uses of cash do not translate well and are full of uncertainty for value investors.
I would argue that this not a case of too much cash being bad, but rather an issue of corporate governance. If a company is aligned with its shareholders and shareholder friendly, this should not be a problem. A lot of technology companies have begun issuing dividends and buying back shares on a regular basis. Apple, Oracle, and Microsoft are just a few examples.
Dasan points out technology stocks don’t make great returns once they have fallen out of favor. The idea behind this is technology stocks are riskier and their franchises are rarely durable. Technology becomes obsolete and companies move into obscurity never to make a penny again.
But, this statement is the very reason value investing works. Without this thought process you would never be able to buy an out of favor company like Cisco Systems. Cisco Systems has moved from a hardware model to subscription based revenues. Microsoft is another example that moved from operating system software to cloud computing. The idea that these companies don’t adapt and their franchises are not durable is untrue. If you were to use Graham’s Simple Way strategy you would have turned up both of these valuable companies before they even started paying a dividend!
One More Example Of A Deep Value Technology Stock
Personal computing is aging and many companies that started in the 90’s and were the growth stocks of the day have now been through multiple economic cycles. Many of these companies have been beat down or have suffered major business issues and have yet to recover. This gives deep value investors an unprecedented opportunity to look at the technology stocks of yesteryear and begin to match them to any one of Benjamin Graham’s value investing framework. A deep value technology stock is possible to find even in today’s aging Bull market.
Rubicon was a great example of a company that was taking the steps to become a valued net net. Rubicon develops, manufactures, and sells monocrystalline sapphire and other crystalline products that are required for LED’s. The business suffered a massive oversupply in the industry and saw its prospects dissolve overnight.
Let’s take a look at how this technology stock begins to fit into another Benjamin Graham investment framework. Rubicon may not have been the most promising deep value technology stock simply due to its burn rate, but upon analysis, it trades below NCAV. Rubicon traded at just $7.15 with a NCAV of $13.96. That’s nearly a 50% discount!
Granted, there are some reasons why Rubicon may not have been a safe Graham net net stock. For one, it had previously issued new shares in the midst of a rapidly decreasing NCAV. That being said, NCAV then started decreasing at a slower rate due to the sale of its long term assets. Rubicon was exhibiting a classic turnaround, showing promise as a possible buy for your deep value portfolio.
While Rubicon is now a shaddow of its former self, buying cheap would have paid off. The stock increased 5x at one point, allowing investors to exit at a tidy profit.
Western Digital and Rubicon are just two examples which show why our mindset toward technology stocks needs to change. More and more, these stocks are beginning to fall in line with Benjamin Graham's Simple Way and Net Net criteria, despite the unique set of issues outlined above. Today, many tech companies would be prime candidates for deep value investment, and Benjamin Graham would not hesitate to put them into his own portfolio, were he alive today.
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