The New Tech Economy

volume xx - issue 2

By Definition: Part 1

A friend of mine called me out recently about the stocks I’ve bought in recent months, and that I advertise New Edge Analytics as a niche proxy hunter. More like a buy-side equity analyst, looking for pure plays in certain tech industries. Software and semiconductors mainly. He aptly pointed out that I went with mega-caps, multiple industries, multiple markets, multiple technology solutions. And he had me there. I had to think about it and remind myself what fits my definition of a proxy.

New Edge exercises a disciplined approach to performance recognition among IT companies. A company has a proxy when NEA attributes outstanding growth to a tangible product that, standing alone, makes a positive contribution to earnings and moves the price of the stock. Staying true to the core, stocks with good fundamentals, New Edge adds emphasis to technical indicators; the patterns that show up in the stock charts of publicly traded companies. I have always used technical indicators to pick entry and exit points but have added weight to those methods to pick growth stocks that would otherwise be ruled out based on their fundamentals alone.

Every seven years on average the stock market gives you the opportunity to shuffle the deck and pick new economy leaders. That is how you must look at bear markets and corrections in the long run – opportunities. It was twelve years ago, using 2018 as the middle of a bear market lasting 17 months, that the S&P 500 dropped over 56%. At the time some of the technologies among the companies named in this essay had been in development for at least several decades. But they were not yet mainstream and hence an investment in these stocks came along with high risk. Some fell hard in the Great Recession. Some mentioned here were under $5 per share – penny stocks.

The companies that suffered with bleeding edge innovation in that bear market have in a few sectors become companies that produce strong growth in earnings now. They enjoy double digit earnings growth year-over-year, and (prior year) quarter-over-quarter. Software and semiconductor technologies that once fit the description of a niche are now developed or acquired by companies that participate in multiple markets. These technologies include subscription software, 4G/5G mobile networks, cloud computing, RISC architecture in data centers, machine learning, artificial intelligence, and high-performance computing. Fringe networks accommodate the Internet of Things and are patrolled by cybersecurity systems.

The IT industry, like most industries, consolidates during bear markets and recessions. Some large companies emerge as winners and address more than one automated solution. The tell is if they can continue to integrate smaller companies, the stand-alone proxies, as well. This means there is still a pipeline of leading-edge solutions. These new economy leaders form the new baseline.

In the context of the recent COVID pullback and recovery, the stocks with the fastest improving prices telegraph who qualifies as new leadership positioned for the next leg up. For now, we need to think about sustainable trends and manage the risk over twelve to eighteen months. A longer bear market affecting all industries is not out of the question, with looming COVID fears and the election in November weighing on forecasts for economic growth.

Twenty-First Century Tech Portfolio

Tech companies with double digit sales and earnings growth have figured out how to move into new markets without assuming much debt. If debt is needed, borrowing continues to be financed with historically low interest rates. There are no significant monetary policy changes indicated by the Federal Reserve. Here are the categories of IT companies that now fit New Edge strategies from the perspective of a buy-side equity analyst:

SaaS

Software as a Service (SaaS) simply means the customer leases or subscribes to a software application running in the cloud, pays usually by the month, and can cancel at any time. There is no upfront purchase by the customer nor annual maintenance fees for a truly SaaS company. Client retention depends on how sticky the solution is. If it is a key necessity inside the company, the company is likely to remain subscribed. Teenagers and their mobile phones, social media, and gaming apps – not so much. The rub for the SaaS companies is a high gross margin percentage, and predictable cash flow. The stock market loves predictable cash flow.

There are just a couple of varieties of SaaS. The application may run entirely in the cloud (in data centers). The application may partially run in the cloud and partially on a user device (the fringe network). The application may run in an enterprise setting, meaning a large organization where the application, database, and network run both in the cloud and in the company’s own facilities. We call this “hybrid cloud computing”.

Chips

Semiconductor companies are coming out of a mild bear market. The rub in this sector is the amount of debt a fabless semiconductor company avoids versus a chip manufacturer. The industry over the last decade has moved to integrated circuit designers who outsource the mass production of the chips they create to a handful of manufacturers. We call these “fabless” or “non-fabricating” chip companies. Sometimes they are endeavoring to create a market. In the end, the emergence of fabless semiconductor companies is now mainstream, has shortened the design-to-build cycle, and helps manage inventories without the need for CapEx and a lot of debt.

Mass production facilities are called foundries, aka “fabricating plants”, and can operate from the early stages of making polysilicon ingots to mass production of wafers and chips. There is a lot of industrial equipment required to mass produce integrated circuits. There are three main foundries who are capable of building nearly all semiconductors – from computer memory, to CPUs, to graphics and solid state drives, to chips in a cell phone. They are Taiwan Semiconductor, Samsung Foundry and Global Foundries (privately held). Intel, Texas Instruments and Micron are examples of North American companies who design and in part have their own foundries. These are called “semi-fab” manufacturers. If we continue to be at odds with China, watch what these companies do to bring mass chip manufacturing back onshore to the US and South America.

Networks

Here is where 4G/5G mobile networks, data centers, telecom carriers, entertainment, and social media live. I would also include fringe networks, here in the context of devices that access the network for computing resources. The Internet of Things. The main 5G carrier companies in North America are AT&T, Verizon, and T-Mobile/Sprint. You could add Comcast and Cox to the mix with satellite feeds, and dozens of independent fiber and cable companies serving secondary markets. 5G is the radio enabler for more applications than cell phones.

5G in an industrial/municipal setting creates revenue for carriers to build infrastructure. This subsidizes the commercial end of the user market such as mobile devices. 5G devices will have applications with intelligent endpoints, sensors, and actuators in all kinds of environments. These include urban smart city solutions, durable gear for demanding indoor and outdoor manufacturing settings, automated logistics and shipping, and automated cars. The list grows daily.

Network Security

Cybersecurity and National Defense are included together at the author’s discretion since beyond traditional thinking about the ability to protect a computer network and data in the private sector, it’s unsaid that cybersecurity is a big area of spending for the military and intelligence communities. Unfortunately, the government doesn’t publish what it spends for network technology and cybersecurity.

You must work hard to understand the spending by the government and revenue opportunities for the cyber companies. Find companies whose primary customers are the military and research the contract awards that they win. Useful information can be found in earnings conference calls, a close look at financial statements, trade journals for defense contractors, and their websites.

Choose companies that make or implement firewalls, who have highly predictable sales and earnings growth. If they make a few strategic acquisitions a year among privately financed cybersecurity companies – the better. The industry is consolidating and the younger, privately held companies are clustering around the firewall manufacturers pre-IPO, or an M&A transaction.

Leading Stocks

Here are the New Edge picks for the second half of 2020. Stay tuned for follow up articles with justification for the companies mentioned here. Hover and click over any stock symbol.

• SaaS: Adobe (NASDAQ:ADBE) and Microsoft (NASDAQ:MSFT). Based on broadening product lines, auto-updates, their embedded base of installations, and relevance with both consumer and business markets. They nearly own your user experience with desktop and Web applications. And you pay by the year/month.

• Chips: Advanced Micro Devices (NYSE:AMD) and Nvidia (NASDAQ:NVDA). Given a confirmed uptrend in the use of RISC microprocessors in data centers, this new industrial opportunity complements their popularity with graphics and gaming. Add machine learning and artificial intelligence to the mix.

• Networks: American Tower (NYSE:AMT). Cell towers figure prominently delivering both 4G LTE radio bandwidth, and in the hosting of new 5G antennas that reach both mobile and stationary devices. AMT is a real estate investment trust that passes lease revenue through to investors.

• Network Security: Mercury Systems (NASDAQ:MRCY) and Palo Alto Networks (NASDAQ:PANW). Both participate with government civilian agencies, the military, and the intelligence community. Both make a few strategic acquisitions a year, some in government space. PANW is my favorite firewall pick.

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