Monday, November 25, 2013

Tech Stocks for Growth & Income (part 2 of 5)

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Tech Stocks for Growth & Income

Part 2: Understanding "Innogration"


James Pearce James Pearce
Technology Sector Analyst

Leo Boeckl Leo Boeckl
Chief Investment Strategist

Jim Pearce is Investing Daily's Wealth Society director and a former investment advisor with 30 years of portfolio management experience. Leo Boeckl, a long-time tech industry strategist and insider, is the inventor of a proprietary valuation model for tech stocks that has worked with uncanny accuracy. Please click on the arrow in the box below to hear them discuss the approach they take to evaluating tech stocks.

Watch the Video

Innovation + Integration = Innogration

Last week we discussed how convergence has been so disruptive in the technology industry over the past thirty years, and its implications for the next thirty years. The tech companies that recognized the extent to which convergence would affect their industry and responding accordingly have been rewarded more than handsomely, while those that did not have been obliterated - or soon will be.

This most critical factor in the life of every tech company is what we have come to call "innogration". The term innogration is derived from the words "innovation" and "integration", and is defined as the act of combining internal product development resources (innovation) with external product enhancement capabilities (integration) to produce a superior product.

Innogration is the key factor for separating the tech companies that are currently doing well but not making the necessary investment in product development from the tech companies which may not be as fashionable but are in the process of creating new categories, and more importantly are the ones that eventually win the category. When tech categories are won the rewards are extreme. The category is dominated by the leader and typically one or two other rivals that are trailing in revenue and market share by significant margins.

Becoming a "Category Killer"

Category killers are the tech stocks which provide the greatest returns to its investors. A category killer is the tech company which has an innogration strategy and has its strategy tentacles spanning multiple categories. Stated more simply, they are anticipating leading the industry by seeking to become the category killer. In the highly Darwinian world of technology the competition never stands still.

For leading-edge tech companies - even the category leaders - ever vigilant focus on innogration must be maintained. A company's innogration plan is critical but it is never the end of the story. Financials are the second half of the equation. How a company is faring with cash on hand and managing debt, as well as quarter-over-quarter revenue flows, provides the fuel to deliver the innogration required to become the category killer. When a company such as BlackBerry loses its decisive critical mass there are no strategies which can save them. We saw this when BlackBerry recently capitulated, announcing that it was up for sale to the highest bidder earlier this year.

Apple, which had lost the personal computer battle to Microsoft in the 1990s, remained as the second runner up in that category. However, Apple maintained the fuel it needed to compete in the Smartphone category because it had cash on hand to invest in its new innogration plans. Those plans have gone on to tip the balance of competition not only for Smartphones, but through a process of creative destruction has also changed the marketplace for PCs. PC sales are in decline as end-users are choosing to do more email, messaging and surfing on their Smartphones, and less on PCs.

BlackBerry's blind spot

BlackBerry, with its initial lead in Smartphones, never dominated the cellular category. BlackBerry saw itself as the niche provider in a business type - cell services. It never saw the Smartphone market until it was far too late to effectively compete. Innogration is critical as it is requires the fuel of cash on hand and/or revenue flows to execute in the marketplace, and BlackBerry failed to recognize this.

Similar to the "blind spot" that prevents a driver from seeing a vehicle right next to them, BlackBerry (formerly RIM) was focused only the road directly in front of it, never realizing it was in danger of falling behind. By the time it realized it had been passed it was already too far back to catch up. Even worse, the road ahead was beginning to curve in another direction. It's only hope of winning the race would have been to replace the motor with one twice as powerful - or innograte - while the car was still moving.

The lesson of BlackBerry is that a tech company that fails to innograte is effectively fighting with one hand tied behind its back. Those that do innograte are not only fighting with their own two hands, but with a couple more acquired from other innovators so it's not difficult to figure who is going to win the fight. We are only focused on who the winners are and they will be. This is where the greatest and most likely long term positive investment returns can be found.

Next Issue: Measuring Innogration to Evaluate Stocks

SPECIAL ALERT: Speaking of BlackBerry (NASDAQ: BBRY), earlier this month it announced that it was suspending the public auction for its stock as a result of insufficient interest. We can't say we're surprised, as ten months ago we predicted that it was headed for the scrap heap and worth no more than the value of its patents and tangible assets. We still think we're right about that, so don't be tempted to rush in and buy BBRY at what may appear to be an oversold condition. With over 500 million shares outstanding and an enterprise value of just over $1 billion, it is difficult to justify a stock price much in excess of $2/share. While a "dead cat bounce" may fool investors into thinking a bottom has been reached, we think this stock should be avoided altogether. BlackBerry pays no dividend, has no market leading product, and is losing money at an alarming rate. With so many healthy tech stocks to choose form, we don't think you should risk your capital in one that must overcome daunting odds just to survive. Our opinion? Avoid BlackBerry at any price – it's a falling knife that is going to hit the floor.

Read Part 1: Technology - A Divergent Sector

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