Like many else in the financial media, I spend my fair share of time thinking about the future of technology companies. From an investment perspective, it is not so much the excitement of tech-related products that draw me in so much as it is the incredibly high profit margins in the industry as well as the immense profitability that results from ease of scalability. In essence, that is the promise of the Internet. You can go from selling 1x to 10x in a way that you never could if your sole operating asset was a restaurant in the rural Midwest.
Having said that, I am also quite aware that, historically, the long-term survival rate of tech companies is quite low and the result of a competitor with a better product tends to be displacement rather than subordination of the inferior product–i.e. If you build a better house, the inferior house continues to exist but maybe at a lower market rate, whereas when Apple build the better Smartphone, the Blackberry all but disappeared.
The money question becomes: Which distinguishing characteristics of a large technology company indicates that it will not only avoid falling victim to this trap, but also continue to compound real wealth for its shareholders?
For long-term readers, you will already be familiar with my partial answer to this question: Businesses like Apple and Alphabet, which are sitting on hundreds of billions of dollars in cash on their balance sheet, will likely be around a generation from now because they can outright buy a seat at the table by purchasing a leading firm in any emerging tech company. I do not think people fully comprehend how, say, having $250 billion conceivably available a la Apple is different from, say, Gilead having $20 billion available. Those added tens and tens of billions of dollars matter and provide about as much long-term security as you could ever hope to find in an investment.
The second aspect, which I have only recently pondered, is the aspect of “trust” as a competitive advantage. We all know what Microsoft Word, Powerpoint, and Excel mean, and we all understand the product’s general reliability, and therefore, these MIcrosoft products become ingrained not just in society at large but are totally ingrained in the business community. By becoming entrenched, it also benefits from the fact that “everybody else uses it”, so legal systems, academia, and commerce rely upon them. Even though Microsoft is a private company, it often gets treated as the assumed standard in areas where it is relevant. Functionally, it is treated almost like a public good even though its operations, profits, and ownership base are privatized.
I see this with Adobe, which has completely torn the stock market to shreds by rising in price from $19 to $238 over the past ten years. It is growing earnings at 25.5% annually. That is don’t-you-dare-press-that-sell-button growth. Own some shares when your child is a freshman in high school, and by the time they graduate high school, the profits have doubled. It’s one of those portfolio trees that is fertilized with Miracle-Gro.
My problem? Everyone else in the business community has simultaneously realized that Adobe is a life-changing stock. Photoshop, Adobe Acrobat, and the Creative Cloud segments are virtual printing presses that only have moderate reinvestment needs but have an insanely entrenched market share.
It was an extreme error of omission on my behalf not to recognize Adobe as an excellent business sooner. I saw, with my very own eyes, how the medical, legal, and business world would only come to accept PDF documents for certain types of files, and only Acrobat was ever used to make edits. The semi-monopoly was right before me.
Now, as I have come to see Adobe as the fast-growing business that is, the stock is trading at a nosebleed valuation. Over the course of 2018, Adobe is expected to earn around $5 per share in net profits. The current price of $238 means that it is trading at 47x current earnings (by current earnings, I mean averaging out the two most recent quarters with the projections for the next two quarters).
Paying 48x earnings for a $117 billion business is not the road to wealth unless you’re Amazon (and even in Amazon’s case, the low profits are the result of immense capital expenditures which is not applicable to Adobe).
It hasn’t been five years since the last time Adobe has been available at a price under 20x earnings.
This type of ebullience will fade.
To state the obvious, Mr. Market really does fade between being a manic optimist and a manic depressive. Royal Dutch Shell, one of my favorite income holdings for a dividend investor, was just at $37 per share a little over two years ago. Now it’s at $76 (the B shares). Valuations doubling and cutting by half really does happen.
When the topic of buy-and-hold investing comes up, the “hold” aspect is often regarded as quaint, very outdated. When this investment strategy is disparaged, I don’t think non-practitioners realize how much homework and preparation is carried out before the initial investment is made. It is more like “Study the investment markets like a maniac, pick a couple dozen supreme businesses, and then pounce when the price arrives and hold on thereafter.”
Abraham Lincoln said that, if he were given eight hours to cut down a tree, he would spend the first six hours sharpening his ax. That is an appropriate motto for buy-and-hold investing. You dedicate vast energy to identifying the business you want to own, wait for the price, pounce, and then conduct light monitoring thereafter. All the contingencies and potential failures are calibrated upfront with the extensive research and the margin of safety that you find for yourself in the price.
Adobe is one of those businesses you wait for it to get near 20x earnings, and then you strike and then hold it for a decade plus to see where you stand. When I say to wait for 20x earnings, that does not mean a price crash to $100 (i.e. earnings of $5 multiplied by a P/E ratio of 20). It could mean that profits grow to $7.50 per share over a 2-4 year time frame, and the price is somewhere in the $150 to $180 range. Getting your price could mean seeing a 20% decline over a three-year period, or it could, in fact, mean a dramatic price drop after a disappointing quarterly performance (every quarter, we see high-growth companies fall after an earnings report that was not quite up to expectations).
From a growth perspective, Adobe should be identified as one of those top 25 businesses to own long term. That said, I just can’t bring myself to pay near 50x earnings for a stock that I am darn sure will see 20x earnings sometime within the next 5-10 years, if not sooner. Now is a great time to get the research and cash ready, so that when the price cometh, you can have the knowledge and capital to strike quickly.
This is a publicly available version of an article shared with The Conservative Income Investor’s Patreon followers on May 21, 2018.
Originally posted 2018-11-30 01:20:30.