The expression “the best defense is a good offense” has been taught by coaches throughout the history of the sports. The point of the adage is twofold: success can be achieved by maintaining control of the ball to prevent the opposing team from scoring and secondly, maintaining possession of the ball keeps the team in control of the game.
The relevance of the expression to investing is this: companies that are able to sustainably excel at innovation and produce new technology may inherently be more defensive. Apple, Google, Microsoft, Intel and Cisco are among some of the most historically innovative companies we own in our investment portfolio. The common denominator among these highly admired brands is all are information technology companies that have, and are today, leading the way in advancements to our daily lives through new products and process improvement. Furthermore, the strong and diversified earnings power of the large technology companies allows them to continue to invest in R&D to maintain their competitive advantages.
On the surface, it is counterintuitive to consider technology companies as more cautious (i.e., “defensive”) positions in a well-diversified investment portfolio. The commonly held view that technology companies are “risky” is understandable, yet outdated as it is largely based on the dot-com bubble of the late 1990s and the subsequent collapse of several of the more speculative or newly emerging internet-based companies.
Fast-forward over 15-years and the dot-com crash is history, but the current reality is that some technology companies have emerged as industry leaders with clear sustainable competitive advantages.
Three examples of companies controlling the game on offense with their new technology advances include:
Microsoft’s Azure Cloud Computing
A pioneer in software and desktop computing, Microsoft has emerged as an industry leader in building out cloud computing. This relatively newer and fast growing line of business for Microsoft allows for companies of all sizes to forego significant hardware and technology infrastructure investments by storing their data on Microsoft’s Azure servers, “in the cloud.” This is changing the flow of information and the way companies of all sizes do business.
Alphabet’s (Google) Moonshots
Google originally made its mark on the world through its dominant advertising revenue business. Yet, more recently Google has driven technology ahead by creating a new holding company, Alphabet, which includes its ad revenue business (i.e., “Google”), as well as the company’s investments in innovation (i.e., “moonshots”).
Examples of these moonshots are self-driving cars, increased internet connectivity worldwide through high speed Fiber networks, and robots for the manufacturing industry. Their aim is to propose radical solutions to wide-scale problems using breakthrough technology. Sounds like a strong offensive strategy.
Apple has created a complete ecosystem designed to attract new customers through leading edge, exciting technology innovations. Once a customer is onboard with Apple, the company is successfully upselling its devices (iPhone, iPad, iWatch, Apple TV, etc.). At the same time, they create an ongoing dependency for Apple customers through services such as iCloud, Apple Pay, and iTunes.
Another defensive aspect of technology stocks is that in addition to constant innovation, the industry sector as a whole is currently undervalued relative to its historical average. One way we measure a stock’s valuation is based on its Price-to-Earnings ratio (“P/E ratio”), which is equal to the current share price of a stock divided by its per-share earnings. The P/E ratio indicates the amount you should expect to invest in a company to receive one dollar of that company’s earnings in return. A low P/E ratio typically suggests that a company may currently be undervalued, and therefore, a good investment.
Trading at a 15.1x forward P/E ratio, the S&P 500 Index technology sector is inexpensive compared to its 20-year average P/E ratio of 22.6x. In investment terms, mean reversion is the assumption that a stock’s valuation will move toward its historical average. The relevance of mean reversion is we believe stocks in the technology industry sector (e.g., software, semiconductors, etc.) are undervalued relative to their respective historical averages; and as such, represent attractive investment opportunities.
Technology today is innovative, fast-paced, and defensive! Like the best sports teams, companies who want to win in this industry are embracing the competitive edge, thinking ahead, and playing with a good offense. We are evaluating their efforts and make smart, defensive investment decisions to keep control of the game.