Saturday, August 11, 2007

Investment Mistakes Part 6 – No Sustainable Competitive Advantage

I purchased Trek 2000 on January 9, 2006 at a lofty (on hindsight, it was darn lofty !) price of 61 cents, after doing a preliminary research on the company. After months of waiting for “true value” to show, I sold out at a loss of 15% (52 cents) on November 13, 2006. Subsequently, as I discovered more about value investing, I realized that key aspects of Trek’s business had eluded me when I did my analysis in the first place, forcing me to admit that I had made a fundamental error. When I discovered that, I bit the bullet and cut my losses. The counter is now trading at 35 cents as of today.

So what went wrong ? First, an introduction to the company. Trek 2000 is a company which manufactured and patented the thumb drive or flash disk, the small storage device which people carry around to transfer and store data. This device is handy and compact, making it a useful accessory for storage of up to 2 GB of data. This device was much preferred to the portable hard drive as the latter is heavy and cumbersome and prone to damage if dropped. A thumb drive, on the other hand, is light, portable and can withstand some degree of external shocks (of course, don’t step on it lah !). Trek 2000 would earn licensing revenues from these devices and it was also into R&D, designing new thumb drives which had biometric features in order to enhance the security features of each drive.

All in all, it sounds like a good business plan since they are the ones who came up with the technology and are thus earning revenues from it. Unfortunately, several factors come into play which severely diminished their ability to compete effectively and to scale up their business. They are as follows:-

a) Commoditization of Thumb Drive – Their flagship product, the thumb drive, was viciously copied in countries like China and sold under other brands’ names. Trek 2000 went on a legal spree to recover damages relating to the other companies’ selling their products, and they won the lawsuit ! Despite this, many copycats still copy the technology and re-brand the products under their own name. Since the lawsuit only covers certain territories, Trek 2000 would have to take expensive legal action in all relevant jurisdictions in order to recover the “damage” to their brand. This is cost-ineffective and puts a large drain on their resources. Thus, brand and product erosion took place which means their product is rapidly being commoditized.

b) Competition – The usual culprit called competition comes in to eat away at market share and margins for Trek 2000. Although the thumb drive commands quite a good market share and pricing, the technology sector usually moves so quickly that one product soon becomes obsolete. This may well be the case for Trek 2000 in the near future, which is why earnings clarity is not present. This was my first “brush” with the technology sector and I had read that for most technology companies, product life cycle from introduction to decline is very short as compared to conventional products such as toasters and ovens. Though thumb drives may seem to be the portable storage device of the future, you never have the certainty that it will be the dominant product and market leader for many years to come.

c) Poor Investor Relations – Trek 2000 was fined S$75,000 for “selective disclosure” of an interview with Reuters which was not announced through SGXNet. The CEO Mr. Henn Tan personally paid off this fine instead of allowing the company to foot the bill. However, it was not the first gaffe from the company and it shows that they are inept at managing proper disclosure practices.

d) Unable to Maintain Pricing Power for NAND Chips – In Trek’s 1Q 2007 financial review, they said that even though sales volume of their products increased, the prices they commanded were substantially lower. This led to an overall decline in sales revenues and profitability was affected as well. Looking forward, this does not seem to be a temporary “blip” and will probably continue to persist for the company in the long run.

After this experience, I was more careful about choosing companies without wide “moats” around their business to prevent competitors from assailing them. Still, I continued to make errors in judgement (which will be described later on) by choosing to purchase UTAC. Currently, as of this writing, I am also contemplating if Global Voice will become my next investment mistake. Perhaps I should start to write about it now as the feeling is slowly creeping in on me. I hope the numbers from their 1H 2007 financial statements will prove me wrong.

12 comments:

Anonymous said...

Good Morning MW,

Like to share my take on technology stocks, recalled vividly that the greatest investor shun this sector as he don't understand it! Technology is fast changing and trends are hard to follow. Look at Apple, today it is voted the most innovative company in the world, and who ever invested it before the iPod days, and now the iPhone, should be laughing all the way to the bank. The company is a trend setter. But, mind you, its past has been tumultuous that none think it will ever gain its ground during the days when Microsoft starts selling software.

My own experience is with Jurong Technology, a company that earn money from contract manufacturing of harddisks and other electronic components from MNC such as Motorola. The stock price swings has been at the extreme ends of the pendulum, causing sleepless nights. It swings overvaluations when Motorola sales better than expected, and swings undervalue when Seagate bought over by Maxtor. The point is that JTIC core business is difficult to understand as it is influence by other companies businesses. I'm lucky to sell JTIC somewhere other than the extremes making a gain with a low entry.

This experience makes me also shun technology stocks. For your GV, guess you know better than me, and I wish you luck. Regards.

musicwhiz said...

Hi morning Anonymous,

Thanks for sharing your experience. Yep, technology sector is truly unpredictable and earnings are hard, if not impossible, to estimate accurately. I have seen Jurong Tech's results fluctuating quite wildly as well and stayed away even though brokerages have been saying "things will get better". In reality, it's hard for things to get better due to volatile conditions, rapid commoditization and increased costs. Thanks for helping to point that out to readers as well.

As for GV, if you can tell from my more recent postings, I am prepared for the worst (i.e. loss-making) and am ready to admit my mistakes and exit all technology stocks altogether. I admit I do not understand their business and operating environment as well as I would like to as a value investor; and this makes me uncomfortable investing in it for the long-term.

Wish you all the best as well for your investments !

Anonymous said...

Hello Musicwhiz,
It is me again. Thanks to your prompt reply to my other entry.
I 'came' from the Hi-Tech world and spent 2X years in the Semiconductor industry. I have gone through many extreme up and down cycles of the industry. Made some good money from CHRT IPO but also lost significantly on their 2003/4 rebound.
My advise and experience on investing TECH stocks is that unless you are very close to the industry and to the technology, it is better to stay away from it. There are always other investment opportunities around.

By the way, would you mind to share some thoughts on asset management?

Early retiree

Ivan said...

hi musicwiz

I had a similar experience as you.

I bought into Creative in 2006 at 12.25, hoping for a turnaround of company fortunes. I harboured a hope that Mr. Sim Wong Hoo will conjure another miracle.

However, as the days wore on, and its market share shrank more and more, I decided to throw in the towel and exited at 9.65.

One mitigating factor was that I received the dividend of USD 0.25 cents after it received USD 100 million from Apple to settle the lawsuit.

But now Creative is trading at a pathetic 6.30

Ivan

musicwhiz said...

Hi Early Retiree,

Oh, so you were actually part of the tech sector and thus knew its ups and downs and how the operations function. Well, most of us laymen, sadly, do not have that kind of knowledge. So I agree with you that avoiding tech stocks is the best thing to do since it is probably not 99% of the population's circle of competence.

As for asset management, I do not know much about it as I do not work in a bank and am not particularly good with finance. Do you mean something like how to spread risk and what to invest in, for example ? Thanks.

Regards,
Musicwhiz

musicwhiz said...

Yo Ivan,

Thanks for sharing your Creative Technology investment experience and sorry to hear that you suffered losses from it. I guess it's a learning experience for both of us that tech companies' fortunes can rise and dip very erratically. I would probably share more on this when I blog about UTAC, which even though I made money on, I would still classify as an investment mistake as I bought without understanding my investment.

Your blog is very consistently updated and is a very good read too. Keep it up ! I will comment on BioSensors once I have enough information on the company, as the DES market can be confusing. However, I did not find any google ads on your blog; are you using Google Adsense ?

Regards, musicwhiz

fishman said...

Hi Mw,

thanks for sharing about your mistakes. Would like to share my thoughts here.

Very early on when I was deciding on which sectors/industries I would like to invet into, I immediately eliminated tech and manufacturing already. The reason being that I have no immediate/intimate knowledge in the sector, and also because I was worried about it's reputation.

Instead I decided to focus on sectors which I can see the action at close hand, like retail and consumers. I think for these companies, it's easier for investors like us to do on-the-ground and immediate research!

Just my two cents worth. =)

musicwhiz said...

Hi fishman,

I agree that it is definitely easier to keep track of retail and consumer goods because of our proximity to such businesses. However, one must also be mindful about the business strategies of each individual company and see if it allows them to maintain a competitive advantage for a long time to come. The problem with retail and consumer goods is the low margin (and consequent necessity to generate high volumes). Thus, any small increase in expenses or COGS might tip the balance and push them into the red.

Not only that, but barriers to entry are low (according to the 5-Forces model) and competitors always try to compete on price, which further erodes margins. Consumers also have low switching costs as most brands sold in retail shops are similar. Some examples of retailers that "didn't make it" are Yaohan and Sogo.

Regards.

fishman said...

Heehee that's why it's important to find a company with strong brand name and is in such a position of a unbreachable moat! Think Gillette!

musicwhiz said...

Hi fishman,

Yes, but brands such as these are hard to find in small little Singapore. The best we can come up with are household names like NTUC Fairprice (which is not listed) and the now fallen from grace Creative Technologies. Even OSIM has succumbed to competitive forces and had their brand equity eroded....

Anonymous said...

Hi MW,

For OSIM, I nearly invested when it came down sharply after results with Brookstone was disappointing. I then did what Peter Lynch said in his books -"go observe the business". when I look at the sales people talking amongst themselves with no customers in most osim shops, i changed my mind and now, I am glad I did not invest. Osim's best times are over, unless they can reinvent themselves.

rgds,

Smalltimer

musicwhiz said...

Hi smalltimer,

Yes, OSIM is a good example of a strong business which has seen its competitive advantage severely eroded. Remaining "premium" is not so easy anymore as other brands' products catch up in terms of quality. Price is increasingly becoming an issue for massage chairs and people no longer see this as being a specialty item only reserved for the rich.

I fullly agree with you: unless OSIM can reinvent and cut costs by closing down more stores, it will be very difficult to see any sustainable earnings improvement in the future.