One of the most common questions we are asked is why we tend to avoid technology-based businesses. This is a very reasonable question given (1) the fortunes created in recent history by technology businesses, (2) the overall ascendance of technology companies over the last 30 years (technology companies have gone from 6% of the S&P 500 in 1990 to over 25% today), and (3) scaling advantages and growth opportunities afforded by technology-focused business models. While these factors may be attractive to many investors, at Kaho we are primarily concerned with the longevity, predictability, and stability of a business’s cash flows. In short, we are looking for resilient businesses that are resistant to change.

One of the greatest threats to our ability to predict cash flows is product obsolescence risk, or the risk that a company’s customers will stop paying for a good or service due to the emergence of a new, better option. According to Murray Stahl, founder of the investment firm Horizon Kenetics, “product obsolescence is such an incredibly powerful variable that, when it does occur, it will determine the fate of an enterprise.” We agree.

What is frustrating about product obsolescence is that it is notoriously unpredictable. Consider the following quote:

“We've learned and struggled for a few years here figuring out how to make a decent phone. PC guys are not going to just figure this out. They're not going to just walk in.”

This comment was made by Ed Colligan, the CEO of Palm, just months before the first iPhone was released in 2006. Here’s another quote:

“Neither RedBox nor Netflix are even on the radar screen in terms of competition.”

That one was made by Jim Keyes, CEO of Blockbuster, in 2008. And another quote:

“With over fifteen types of foreign cars already on sale here, the Japanese auto industry isn't likely to carve out a big share of the market for itself.”

Businessweek made this claim in 1968, before Japanese automakers subsequently took almost 40% market share in the United States. And finally:

“What use could this company make of an electric toy?”

This last comment was made in 1876 by William Orton, President of Western Union, when offered the chance to acquire the intellectual property of a new product. He was referring to the telephone.

Based on the fact that you are most likely not carrying around a Palm Pilot in your back pocket, have not browsed the aisles of Blockbuster in quite a while, have probably seen one or two Toyota Camry’s on the road, and don’t communicate with your BFFs via morse code, it is clear that these people were all incorrect in their estimations of product obsolescence. We don’t include these quotes simply to point out historical blunders, but rather to illustrate just how hard it is to know the impact of what competitors and new entrants are cooking up in their R&D labs.

While it may be nearly impossible to know if a company’s products or services are at risk of obsolescence, one factor may sway the odds for or against a business - the typical product life cycle of an industry. Consider the following illustration of the prototypical life cycle curve:

Generally, the shorter an industry’s average product life cycle is, the greater the risk of product obsolescence across any investment hold period.

Technology companies in particular typically have very short product life cycles. Stahl writes, “the objective study of history would suggest that technology is an industry characterized by vicious cycles and intense competition that frequently results in the extinction of many of its participants.” Why is this? According to Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, the same characteristics that allow technology companies to scale quickly (low capital intensity, general lack of regulations, low switching costs, rapid adoption due to electronic means of distribution, etc.) also make them vulnerable to new entrants with better mousetraps. Consider Damodaran’s chart below:

This is why Stahl writes, “technology investing carries a risk not generally associated with other types of investing.”

We prefer to invest in our companies for the long term, a practice that Damodaran advises to avoid when dealing with technology companies. He writes, “today's tech superstar can become tomorrow's dog. If you buy a tech company, you should be revaluing it at frequent intervals, selling it, if the price exceeds the value significantly.” So while technology companies may be superb investments for some investors - perhaps ones that are willing to buy and sell frequently - we are generally happy to look for lasting, stable, and predictable cash flow streams in other places.

Why We Avoid Technology-Based Businesses