MARKET OVERVIEW

Last week provided the perfect illustration of why our theory of innogration is critical to investing in tech stocks. Since we launched Smart Tech Investor four months ago we have hammered away at the importance of focusing on the extent to which a company has the resources available to implement innogration which we measure using our proprietary valuation model, the Boeckl Innogration Quotient (BiQ).

However, it is equally vital that the current valuation assigned by the stock market is reasonable, and provides opportunity for future growth. That is why we convert the BiQ score for each company to our Smart Tech Rating (STR) by comparing its forward (12 months) estimated earnings multiple to that of its peer group.

From an investment perspective the ideal scenario is a company with a high BiQ along with a low valuation, paving the way for almost certain gains in the not-to-distant future. Of course, the opposite set of circumstances – a low BiQ combined with a high valuation – is a disaster waiting to happen and can make for a very profitable short sell transaction. Admittedly it is rare to find many companies that reside at either of those extremes, as more often than not the stock market will eventually recognize its mistake and adjust valuations accordingly before conditions become that extreme.

Much more common are companies that have a fairly average BiQ, with a score in the 3 – 7 range (on a scale that goes from 0 to 10). It is in this “muddled middle” that the STR can be of most value, as it quickly separates the overvalued pretenders from the undervalued workhorses that will soon rise to the top.

Surprisingly, even the highest profile tech stocks can be grossly mispriced. For reasons that I have never understood most tech investors seem to believe that in the short run value doesn’t really matter so they are willing to pay almost any price to own a trendy name like Amazon.com (NSDQ: AMZN), Netflix (NSDQ: NFLX) or Facebook (NSDQ: FB), while eschewing legacy companies such as Apple (NSDQ: AAPL), Microsoft (NSDQ: MSFT) or Western Digital (NSDQ: WDC) as being outdated and no longer “current”.

So let’s go back to last week. After the market closed on Thursday, Amazon announced quarterly results that shocked the market. Of greatest concern was a 23 percent spike in expenses, all of which (and more) was attributable to a 29 percent jump in fulfillment (shipping) costs. To add insult to injury, the company unapologetically included a comment that it expects an operating loss of $50 billion or more during the current quarter.

The following morning Amazon’s stock dropped almost 10 percent, closing the day at $303. That’s a far cry from where it was just three months ago when we reiterated our short sell recommendation on it while trading near $400. Leo and I have spent a lot of time evaluating Amazon, and quite frankly we can’t justify a price above $250 for it even under the most optimistic of assumptions so we think it still has at least another $50 to drop (note: this morning the stock dropped to $288 before popping back up above $300, probably the result of sell orders that piled up over the weekend after its shareholders had a chance to digest Thursday’s one-two punch of awful news).

The reason why we have been advocating short-selling Amazon all along goes back to our theory of innogration, which resulted in its stock receiving one of the lowest STR scores of any tech company that we cover. The problem was not so much its BiQ, which is a respectable 5.2, but its STR which is a pitiful 0.6. In other words, while Amazon has a decent game plan for innogration, the stock market has been valuing it like it had already won the game and was paying big dividends to its shareholders while piling up profits.

That description does not fit Amazon, but it does apply to Apple. Not only does Apple have a very solid BiQ of 7.0, but it is also undervalued to its peer group based on forward earnings so its STR is an impressive 9.6, or more than ten times the STR of Amazon. So, if our theory of innogration is correct and our valuation model accurately measures it, then we should be expecting some good news out of Apple, right?

And that’s exactly what we got last Wednesday after the market closed. In addition to announcing much higher sales for its line of iPhones than expected, especially in the fast growing Asian market, Apple also revealed that it will be splitting its stock 7 for 1 this June so that it can be included in the Dow Jones Industrial Average (unlike the S&P500 which is market cap-weighted, the DJIA is price-weighted so Apple’s stock needs to be in line with the midpoint of the index’s other components in order to avoid skewing the average).

On Thursday Apple opened 8 percent higher, and by this morning was almost 15 percent above its closing price last Wednesday. Meanwhile, Amazon continues to lose favor with investors, moving in an almost equal and opposite direction as Apple. If a picture really is worth a thousand words, then the chart below could substitute for this entire issue of ST50WM. 

Prior to last Thursday the two stocks were trading almost in lock step with one another, but since then their paths have shot in opposite directions. This is precisely what we anticipated when we wrote about Amazon in a February article, and why we named Apple as “The One Tech Stock to Own in 2014” in our inaugural issue of Smart Tech Investor last December. While others may complain that there was no way to see this type of divergence coming, quite frankly we felt it was obvious from the beginning based on our theory of innogration and the STR scores for the two companies.

By the way, Apple is only the sixth highest scoring stock in our Investments Portfolio based on its STR (9.6); the top five currently are Ricoh Company/OTC: RICOY (12.4), Qualcomm/NSDQ: QCOM (11.1), Cisco Systems/NSDQ: CSCO (10.7), Western Digital/NSDQ: WDC (10.1) and CA Technologies/NSDQ: CA (10.0).  As 2014 unfolds expect to see companies like these gradually rise to the top as many of their overvalued peers lose the support of their increasingly disillusioned shareholders.

NASDAQ Composite Index:

Friday, April 11 = 4,075.56

Year to Date = – 1.6%

Trailing 7 Days = – 0.5%

Trailing 4 Weeks = – 1.3%

PORTFOLIO UPDATE

In last week’s edition of Smart Tech Investor we introduced our new Next Wave Portfolio, which consists of small cap stocks that we feel have the potential to become winners in the four categories that we believe represent the core elements of the second half of the current long macroeconomic wave: Big Data, Mobility, Cloud, and Social. 

However, since most small tech stocks tend to have rapidly changing financial statements and do not pay a dividend, our BiQ/STR valuation metric does not work as well for them as it does for larger stocks operating within a more structured cash flow model. For that reason we recommend them primarily on the strength of their strategy for innogration, and the extent to which their financial performance appears to be headed in the right direction.

If you missed it last week, here are the first four companies that we are adding to the Next Wave Portfolio, and we will be adding more in the months to come.

Big Data: NICE Systems (NSDQ: NICE) is rapidly becoming a major player in the areas of cybercrime prevention and homeland security. As the recent invasion of Target’s POV system illustrates, the cost of admitting that hackers have successfully breached the financial records of a major online vendor is enormous so companies are investing heavily in prevention systems. Combined with escalating demand for enhanced facial recognition software and other tools used to fight terrorism in real time, NICE is positioned to benefit from two major growth trends. Amazingly, the company actually trades at a 35 percent discount to its peer group based on forward earnings, and pays its shareholders a nifty little 1.3 percent dividend to boot.

Buy NICE up to $50.

Mobility: Silicon Motion Technology Corp (NSDQ: SIMO) is owned by a Korean company and based out of Taiwan, where it designs and markets advanced semiconductors that expand the storage capacity of handheld computing devices including smartphones, tablets, pads and cameras.  These semiconductors also use less power than a standard processor, thereby extending the battery life of the devices. With China and India expected to be the two biggest growth markets in the world for portable computing over the next ten years, it’s hard to imagine how SIMO cannot end up being one that trend’s primary beneficiaries.  It trades at a 20 percent discount to its peer group on forward earnings, and pays a generous dividend of 3.6 percent.

Buy SIMO up to $22.

Cloud: Ebix, Inc. (NSDQ: EBIX) is taking the Cloud to the insurance industry, providing web-based solutions to carriers, agents and underwriters so they can manage data more efficiently. Instead of pulling together bits of data from multiple sources that may be out of date or inaccurate, their customers can integrate current data and identify errors and omissions before they occur. However, the stock is valued like a stodgy insurance company at only 10 times forward earnings instead of like the growing cloud company that it is becoming, so it’s a bargain and pays a dividend yield of 1.8 percent.

Buy EBIX up to $20.

Social: Kongzhong Corp (NSDQ: KONG) is the closest thing to a pure play on the Chinese mobile gaming market you will find. Internet gaming is rapidly converging with Cloud and Social to become a critical experience for the youth market, which combined with the rapidly escalating smartphone market in China should result in explosive growth for KONG. With annual sales of $173 million in an industry estimated at $82 billion and growing quickly, there is ample room for KONG to increase sales without cutting into its very healthy 12 percent profit margin.

Buy KONG up $14.