From 1911 through 1991, American tech stocks delivered returns of 8.3% annualized, almost two percentage points below what a general basket of large-cap American stocks produced over the same time frame. And much of that was driven by IBM. If IBM were removed from this historical measuring period, the tech stocks would have only produced 5.2%.
Why? Because of the immense wipeout risk. Unlike a candy bar manufactured by Mars, Inc. or Hershey, which can be slightly tweaked and repackage and sold for profit over and over again, the typical life cycle of a technology company has been that (1) a new product is introduced; (2) it saturates a market, creating an avalanche of wealth within a few short years; and (3) the product is replaced by the better mousetrap, leaving sales of the former product to wither due to obsolescence as bankruptcy or some sort of dulitive event occurs.
In summary, the wild ride from 0% market share to 60% market share down to 4% market share is why tech stocks have tended to be the province of the speculator or medium-term investor rather than the estate planner or the multigenerational investor.
Now, we are seeing how the financial strength of tech titans is sufficient to “buy their way” into the next generation.
Many of you presumably read the Sunday afternoon news that IBM is buying Red Hat, a fast-growing enterprise technology firm, for $190 per share in cash which is a total cost of $34 billion. Although IBM’s decision to pay a premium of 80x earnings has and will receive scrutiny, IBM is nevertheless getting its hands on ownership of an asset that has grown revenues by 22% annually over the past ten years and is expected to double its revenues within the next three years.
Historically, tech firms would have to pay engineers well, carrying high expenses and pension obligations to earn a 16% net profit margin. The tech firm of today carries a 25% to 48% profit margin without the simultaneous pension and other cost commitments. This has freed up balance-sheet cash that can be used to acquire smaller firms that are outpacing them on a future technology.
IBM, in a world where it can make no acquisitions due to balance sheet concerns, would face the dinosaur problem that doomed its historical peers. But when it can buy its way to the future, the old legacy hardware can provide the ongoing cash to act as bridge to the future that includes businesses like a fully matured Red Hat twenty years from now.
In particular, firms like Alphabet, Microsoft, and Apple are sitting on hundreds of billions of dollars in cash. If their core businesses ever faltered, they could suspend the dividend, and buy a collection of fast-growing smaller peers with its cash on hand and/or limited financing.
In the past, it would require the issuance of massive blocks of stock that would dilute the effect of the acquisition or act as a bar on the acquisition altogether.
Obscene cash balances change the analysis. People like Ben Graham, John Neff, and Irving Kahn lived in a world where tech companies had once cycle to creative wealth and you had to time your jump off the swing set before you flipped. Large cash balances can create a never-ending cycle that bridges growth to growth, with the risk being the need to get the acquisition right (i.e. if Microsoft acquires Nokia over and over again, the value of the cash is obviated).
If someone told me that they were going to put a sizable chunk of their net worth into Apple, Alphabet, Cisco, and Microsoft, on the grounds that their multi-billion cash hoards will translate into an impressive collection of not-yet-purchased subsidiaries, I would not fault the premise. What IBM is doing now with Red Hat, these other tech firms will be able to do when their core cash engines fall into economic disfavor. For the student of markets, certain cash-rich tech firms can move from the fringe to the center of the buy-and-hold forever map.