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In an increasingly competitive environment, it is also plausible that the Internet’s undoubted benefits will eventually diffuse so widely that the ’Net becomes part of the basic commercial infrastructure which all enterprises must use in one way or another in order to remain in business. If so, then established companies which harness the opportunities provided by Internet and other technologies (as opposed to the developers of those technologies) may benefit most from it.
For Consumers, Technology Is an Unambiguously Good Thing
If they are commercially viable – and it is important to recognise that they usually are not – technological developments such as e-infrastructure, e-commerce and e-business deepen the division of labour and provide more “roundabout” methods of production and service delivery.
In so doing they have two beneficial effects. First, they increase the variety of goods and services on the market, present them to consumers in a more convenient form and thereby increase consumers’ scope for choice. Consumers’ ability to choose is the basis of individual morality and responsibility, and these virtues can be exercised only against a backdrop of personal freedom. It is thus no accident that technological progress and personal liberty go hand in hand. Second, commercially successful technologies improve consumers’ standard of living: they enable businesses to supply more and better-quality goods and services at the same price, equivalent qualities and quantities at cheaper prices, or more and better goods and services more economically. Technological progress, in other words, exerts a beneficially deflationary impact upon production.
For both reasons, technological progress and prosperity are most prevalent in free markets and open societies. Hence the Internet is regarded with apprehension by illiberal governments as an insidious and “chaotic” phenomenon which must be regulated (in Western and developing countries) or repressed (in Third World dictatorships). It is therefore desirable that the impact of the Internet be as revolutionary as that claimed by its promoters. Whatever its precise impact (which is pointless to predict), it is reasonable to expect that consumers of goods, services and information, rather than their producers and custodians, will benefit disproportionately from e-infrastructure, b-business and e-commerce.
For Its Producers (i.e., Technology Companies and their Investors) and Intermediate Consumers (i.e., Other Businesses and their Shareholders), Technology Is an Ambiguously Good Thing
Technology clearly provides unambiguous benefits to consumers. Equally clearly, however, not all – indeed, relatively few – technological innovations become commercially successful. Those which do not incur losses (in the form of opportunity costs or permanent loss of capital) for their owners and backers. Economic history is replete with examples of companies and entire industries which possessed seemingly revolutionary technologies but were unable to commercialise them successfully. In this respect hi-tech companies resemble mining prospectors: they must do much research (or guesswork), explore extensive territory and drill many holes before (once in a blue moon) finding a mother lode. Drawing another analogy, like the homesteader the technology company’s objective is to claim territory now and ascertain later whether it is fertile. Many more prospectors, homesteaders and technology companies go to the wall than strike it rich.
Economic Fundamentals
Some hi-tech company failures can be attributed to entrepreneurial error and business miscalculation; others, however, may stem from more fundamental causes. Most importantly, the economic fundamentals of many technologies are not (from an investor’s perspective) as favourable as their promoters and investors typically suppose. We have seen that, given certain assumptions, e-infrastructure possesses positive fundamentals. But it hardly follows that all e-infrastructure companies will be able to reap them. And although there will be some exceptions (“Infomediaries” are one possibility), e-business and e-commerce firms do not generally possess compelling fundamentals: most notably, barriers to entry into their markets are very low, property rights difficult and costly to enforce and the software on which they depend virtually costless to copy and distribute.
If this diagnosis of fundamentals is even remotely close to the mark, then e-business and e-commerce activities risk becoming commodities which companies compete to provide most efficiently and cheaply. This prognosis is the polar opposite of that envisaged by leaders of and investors in Internet companies. Instead of finding a new pot of gold, dot coms are entering markets in which fierce competition and contracting profit margins are the norm. It is ironic that in these respects e-business and e-commerce may be little different from the smokestack and bricks-and-mortar businesses which they often disparage.
Complexity and Unpredictable Development
By its very nature, technology is technical, arcane and complex. Given these attributes, together with its progressively more rapid rate of advance and expansion since the Industrial Revolution, experts can claim to understand no more than very specialised areas of technology. Further, they can command no more than an imperfect understanding of the wider field within which their technological speciality lies. And given the spontaneous and sporadic (“Eureka!”) nature of technological progress, not even experts can accurately divine the timing and direction of its future development. At best, laypersons can comprehend technology and its development very dimly; and usually they do not understand it at all.
It is for these reasons that Warren Buffett, the world’s most successful investor and doyen of value investing, has never invested in technology companies. This position is somewhat surprising, given Buffett’s close and longstanding friendship with Microsoft Chairman Bill Gates. Their camaraderie notwithstanding, Buffett has stated repeatedly that he does not possess the competence to understand (and therefore to value) technology companies. “I’ve been an admirer of Andy Grove and Bill Gates... But when it comes to Microsoft and Intel, I don’t know what the world will look like ten years from now, and I don’t want to play in a game where the other guy has an advantage.”
Buffett has also stated: “if I had to bet on anybody [in the technology field], I’d certainly bet on Microsoft – and heavily. But I don’t have to bet.” (Buffett’s use of the verb “to bet” is telling). Berkshire’s Vice Chairman, Charlie Munger, echoes Buffett’s thinking. “The reason we are not in high-tech businesses is that we have a special lack of aptitude in that area. The advantage of low-tech stuff is that we think we understand it fairly well. The other stuff we don’t and we’d rather deal with what we understand.”
Value investors thus tend to invest in companies whose products and their uses are easily understandable to non-experts. Comprehension of a company’s basic business is the key to understanding the economic fundamentals of the industry within which it operates. Berkshire Hathaway’s investment in General Foods Corporation in the early 1980s provides a typical example. GFC owns familiar brand names such as Tang, Jell-O and Kool-Aid. At the time of Berkshire’s purchase, and as one justification for it, Buffett stated: “I can understand Kool-Aid.” High-tech companies clearly do not have this attribute. (In October 1985 GFC was sold to Phillip Morris; proceeds from the sale earned Berkshire a modest profit of $335 million).
Displacement Effects
Those technologies which defy the odds and become commercially successful displace older technologies. These technologies, in turn, are sooner or later displaced by newer and better technologies. In the longer term, this process is beneficial: it provides a discovery mechanism and price signals which free resources from uses which obtain relatively low returns and release them for applications where they can achieve higher returns. In the shorter term, however, it can displace existing businesses and their workers. It was no fun being a horse or a carriage maker when the tractor and motor car were bursting on the scene, or being a guild craftsman when mass production was made possible. For the same reason, being a bank teller or stock broker is no more likely to be enjoyable at a time when ATMs and the Internet are becoming ubiquitous.
Reflecting their contrarian nature, value investors thus focus on the absence of technological change. They prefer to invest in companies and industries in which fundamental technological change is likely to be limited and manageable, whose economic fundamentals are stable as well as favourable – and therefore whose fortunes and characteristics can (roughly and cautiously) be projected into the future. These companies tend to produce goods and services whose demand is not rendered obsolete by technological advancement. Chewing gum provides a seemingly-flippant yet telling example. People chew gum today in precisely the same way that they did 50 years ago. Technological improvements are very likely to change the process by which gum and certain other consumer products are manufactured; but they are very unlikely to affect (let alone obviate) consumers’ demand for these products. In Buffett’s words, “I don’t think the Internet is going to change how people chew gum.”
Value investors thus look for companies which resemble (the analogy is Buffett’s) impregnable castles which are surrounded by deep and wide moats and which possess honest and competent leaders. The castle’s strength derives ultimately from its leader’s acumen; but since good leaders are few and difficult to replace (and all have human foibles and deficiencies), the moat is reassuring because its depth, width and permanence deters companies which are considering an attack. Management is clearly important; but favourable economic fundamentals are just as important. Businesses require “moats” in order to protect against other companies who can place an equivalent product on the market at a slightly cheaper price. Value investors appreciate franchise value, respect pricing power and therefore search for companies with strong positions in their respective markets, whose goods or services are difficult to duplicate and which have a track record of profitable operation. Surprisingly few technology companies possess these characteristics.
Financial Position and Longevity
Companies which successfully develop and market a particular technology will not necessarily be able to translate its benefits into returns for their shareholders. Even if were true (it usually is not), the statement “technology X will revolutionise business and benefit society” does not imply the statement “investing in companies which produce and license technology X will make us rich.” As described in Part IV, aviation and air transport provide excellent counter-examples.
Given its specialised nature and the rapid rate at which it advances, with few exceptions the companies which develop technologies from scratch tend to be financially precarious and short-lived. Benjamin Graham reported in The Intelligent Investor the results of various analyses of listed technology companies which he had conducted over the years. In September 1971, for example, 46 were listed in Standard & Poor’s Stock Guide. Of these, 26 were reporting losses and only 5 were paying dividends.
The December 1968 Stock Guide listed a virtually identical number (45) of technology companies. Tracing their fortunes from 1968 to 1971, Graham found that the share prices of just two had increased, the prices of 8 decreased by less than 50%, the prices of 23 decreased by more than 50% and 12 had been delisted. In Graham’s view, “the harrowing results shown by these samples are no doubt reasonably indicative of the quality and price history of the entire group of ‘technology’ issues. The phenomenal success of IBM and a few other companies. produce a spate of public offerings of new issues in their fields, for which large losses [are] virtually guaranteed.”
This has proved to be the experience of Peter Lynch, one of the most successful funds managers of the 1970s and 1980s. Lynch wrote in Beating the Street that “I note with no particular surprise that my most consistent losses were the technology stocks, including the $25 million I dropped on Digital in 1988, plus slightly lesser amounts on Tandem, Motorola, Texas Instruments, EMC (a computer peripherals supplier), National Semiconductor, Micron Technology, Unisys, and of course that perennial dud in all respectable portfolios, IBM. I never had much flair for technology, but that didn’t stop me from occasionally being taken in by it.”
Shareholder Returns from Technology
The possession of superior technology can contribute towards the generation of returns to a company’s shareholders. But it is a contributing factor, and is neither a necessary nor a sufficient condition, for the creation of such returns. In order to earn returns for their shareholders, companies must develop competitive advantages in the marketplace (or, to return to Buffett’s analogy, dig a deep and wide moat). They can do so by producing a product for which there is great demand but few or no suppliers. Alternatively (since few products have these attractive attributes), they can cut production, inventory and associated costs; learn more about their customers and suppliers; anticipate their customers’ preferences and give them better service; and create new sources of revenue and enter new markets. Technological innovations such as the Internet, e-business and e-commerce, in short, can help companies to do these things. Critically, however, these innovations cannot do it for them; nor can they do so single-handedly.
Hence the conclusion of Fred Hilmer (CEO of Fairfax Ltd and former Dean of the Australian Graduate School of Management): “the opportunity for fundamental competitive advantage via [the Internet] is limited. Put another way, advantage in user industries is rarely created by purchased technologies.” Any business (whether or not it uses the Internet) which offers its customers value for money will remain in business; and any business which can use the Internet or any other technology to provide even better value for money is going to thrive. The message (customer service and value for money), however, is more significant than the Internet medium.
The All Ordinaries.com
When Australians prognosticate about the Internet and the transformations of business and society which it may cause, they tend to think computer geeks, under-30s worth tens of millions, Looksmart, Ecorp and Solution6. Although these upstarts currently have paper wealth and market capitalisations somewhere in the stratosphere, the more pervasive effects of e-infrastructure, e-business and e-commerce may be more likely to be felt by – and their benefits captured by – the long-established behemoths in the ASX.
We have found, generally speaking but with some notable exceptions, that e-business and e-commerce firms (i.e., the suppliers of Internet goods and services) do not possess compelling fundamentals. As we have also seen, however, consumers of these goods and services may be able to reap significant gains from the Internet; and in a competitive environment it makes sense to assume that those which have not integrated e-business and e-commerce activities into their operations may find themselves outmanoeuvred by others who have done so. CEOs at more and more of Australia’s largest corporations are therefore taking the Internet more and more seriously and implementing some sort of strategy with respect to it. But as in the U.S., so too in Australia: to date it is rare to find a Chief Executive who is willing (as is Jack Welch of General Electric) to “destroyyourbusiness.com” – i.e., change the company’s existing business and operations radically.
Prognosis
The objective of e-business and e-commerce is to enable companies which adopt these strategies to cut costs, eliminate middlemen, attract new customers and thereby increase profits. Established, well-managed companies in mature markets may be best placed to take advantage of these developments. Based upon scattered and anecdotal evidence from the U.S., however, investors should not expect dramatic returns from these Internet strategies during the next several years. Building state-of-the-art Web sites and putting entire companies on-line can take several years and cost hundreds of millions of dollars. And the efforts of established companies will be harried by upstarts.
Although they are unlikely to be dramatic, these returns are nonetheless likely to be significant. The most recent scenario, cited in the Wall Street Journal in December 1999, is that Internet strategies might cause profits in the companies which comprise the Dow Jones Index to increase by an average 2-3% in the next couple of years. At the most aggressive Dow companies, profit increases of up to 10% might be attributable to Internet activities. Combined with reductions in costs and other efficiencies, e-business and e-commerce activities have the potential to add 10% to the average Dow stock’s earnings per share.
 
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