Paul McWilliams, editor of Next Inning and a self-described nerd walks us through the complexities of analyzing tech stocks, and highlights some favorite bets on broadband.

Steve Halpern: We're here today with Paul McWilliams, editor of Next Inning. Unlike many in the advisory community who focus on all types of stocks, you've developed an industry-leading expertise in one sector—technology. Could you tell us a bit about your background and your attraction to technology?

Paul McWilliams: Well, I guess you could say I'm a bit of a nerd. I grew up in the tech sector running a tech company for 20 years; but as much as I love technology, what really interests me is the study of business models.

Steve Halpern: And one of the places that interested readers could see about these business models is, every quarter you compile a special report called the State of Tech in which you provide an in-depth analysis of some 70 different stocks. It's probably the most ambitious project I've ever seen in the advisory world. Can you tell us about this report?

Paul McWilliams: Oh, thank you for your kind words. The State of Tech is a challenging endeavor, but that's what makes it worthwhile.

State of Tech is designed to help readers audit their thinking and adjust their strategy for the upcoming earning season, which is when stock prices tend to make their biggest moves during the year.

In our July 1 edition, which ran a total of 160 pages, I covered, as you mentioned, 70 tech companies that participate in sectors ranging from semiconductor wafer fabrication to finished goods. The report covers all the mega-cap companies like Apple and Cisco, as well as a number of small and micro-cap companies.

Advancements in technology are generally enabled at the front end of the tech food chain and then implemented by companies in the back of the food chain.

If we understand this process from womb to tomb as I say, we can more accurately spot the companies along the food chain that are likely to benefit, and the companies that are likely to be disrupted.

However, that just gives us a place to start. From there, we need to dissect the business models of the various companies.

Steve Halpern: Is that why you dedicate so much of your efforts to a fundamental evaluation?

Paul McWilliams: Yes, a lot of investors are either intimidated by a fundamental evaluation or they use short-cut formulas that often lead to bad decisions.

What successful investors look for are pricing mistakes caused by these bad decisions. Fundamental data doesn't need to be intimidating.

Prior to moving to the finance side of the business, I spent 20 years as a CEO of a tech company that I founded and subsequently sold. When I ran the company, I learned about the fundamental data and more importantly, what drives changes in the data.

What investors need to spot are the unexpected changes. In other words, changes that are not included in the price of a stock.

While a very large percentage of my readers are professionals who run hedge funds, or mutual funds, or private investment groups, I take a lot of time explaining the fundamental data for companies in the industry sectors so that even the average person on the street can understand what makes a given business model tick, and with that, what might change its course.

In State of Tech, the first 45 pages are dedicated mostly to fundamental data and the accompanying explanations of what it means and why it's important.

In the 100 or so pages that follow, I provide company-by-company specific commentary that explains how I think the model will work out going forward and what I think the stock is really worth.

Steve Halpern: What sort of data do you focus on?

Paul McWilliams: In addition to the basic data you'll find most everywhere, I provide a level of detail you won't find on financial websites that helps readers better understand the core valuation.

Some of the more unique evaluations I present include free cash flow evaluations relative to tracked earnings. Warren Buffet calls this “owner's earnings.” Another unique data point I call operational leverage ratio.

Steve Halpern: Can you explain what that is and why it's important?

Paul McWilliams: Operational leverage, the ratio that I call operational leverage, shows the number of gross profit dollars a company earns from each dollar it invests in operational expenses. This is important for many reasons. It tells us how well senior management is investing its resources.

It's also one of the very few pieces of trailing data that has reasonably good predictive value for future results.

Steve Halpern: With all of this data as a background, where are you choosing to invest today?

Paul McWilliams: Well, I'm allocating my risk budget in a number of places. I've actually got a fairly widespread of bets on the table right now and I disclose those openly to Next Inning readers.

Since time's running short, let's focus on one paradigm I think we can all agree will play out favorably going forward.

I think we can predict with reasonable certainty that the world has a nearly insatiable appetite for bandwidth. What's interesting here is companies at the front end of the food chain have only recently delivered the tools that can economically enable the delivery of the bandwidth in services that we all crave.

A lot of investors think tech companies can deliver solutions almost instantly, and then wonder, why did my investment not pan out so quickly? This simply isn't how it works in tech. Even in industries that have short design and product cycles, it takes several generations to deliver what consumers really want.

Look at smartphones we see today versus what we saw three years ago. It simply couldn't happen overnight. In some sectors, the puzzle's very complex and it also depends on capital spending cycles. In the bandwidth deployment story, we've seen a little bit of both. We're waiting for the right technology and waiting for the capital spending cycle.

What we're seeing now, however, is both factors are coming together and there will be a bunch of companies that benefit from the conversions.

Steve Halpern: Would you be kind enough to talk about a couple of those companies for us?

Paul McWilliams: Oh, yeah. Let's touch on just a couple of them really quickly. First off, there's Finisar (FNSR). Finisar is a world leader in fiber optic components and substances. It's not as big as JDSU in revenue, but half of JDSU is capital equipment. So, it doesn't compete with Finisar.

Finisar operates with a business model that carries a high fixed cost. This is where studying a business model is really important. A high fixed cost business model means it takes a certain amount of revenue to overcome the fixed cost; but after that, the marginal profit, or the profit on the next dollar of sales, is very high.

I pointed to this fact last year when some misdirected analysts were rating Finisar as a sell and the stock was trading in very, very low double digits.

Since then, we've seen the outlook for Finisar improve significantly and at its recent peak, the stock was priced at more than twice where I suggested entering it. It has since fallen back a little bit too where I think it's at a really good point to accumulate shares now.

Steve Halpern: There's a second company that you said was interesting?

Paul McWilliams: Oh, absolutely. Another company that most investors probably have never heard of is a tiny little Israeli semiconductor company named EZChip (EZCH).

EZChip absolutely dominates the world of Layer II and Layer III network processing used in edge routing applications. This all sounds pretty geek to most people I'm sure, but I explain it in pedestrian-level detail in my reports.

The installation of high-performance edge routing is going to be the focus for the current capital spending cycle. According to forecasts and the results we've seen from EZChip customers like Cisco, demand should continue to accelerate substantially going forward.

I think Cisco reported, oh, 60% year-over-year increase in sales for their ASR 9000 edge router, which is totally dependent on EZChip's Layer II and III solution.

However, for some strange reason, analysts think EZChip is directly threatened in its core markets by companies like Broadcom and Marvell.

I've studied the sector and the offerings from Broadcom and Marvell closely and I think these analysts are wrong. EZChip trading below $30 is an easy buy.

There are a lot more of these stories that we can cover, but time's running a little bit short; and if your readers are interested, they can always check out the website and take a look at our free trial offer.

Steve Halpern: Well, I'd encourage them to do that. I'm always fascinated reading your reports. You do an incredible job and I'd really like to thank you for joining us today.

Paul McWilliams: Well, thank you, Steve. I appreciate your time.

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