A New Strategy for Smart Tech Investors

12/16/2013 10:00 am EST

Focus: TECHNOLOGY

James Pearce

Director of Research, Investing Daily

Leading newsletter publisher Investing Daily is launching a new publication today; Jim Pearce walks us through the strategy behind Smart Tech Investor, highlighting how its indicators determine over- and under-valuation in the sector.

Steve Halpern: Investing Daily is known for some of the advisory industry's most popular and long-running newsletters, including the flagship Personal Finance, and we are here today with Investing Daily's Wealth Society director, Jim Pearce. How are you doing today?

Jim Pearce: Great, Steve. How are you?

Steve Halpern: Very good. The timing of this interview is no accident, in fact, today is the launch of your latest newsletter, Smart Tech Investor. First, can you give us an overview of why you have chosen the tech sector for this latest product launch?

Jim Pearce: Sure. Actually, there are several reasons; one, of course, is that there is an awful lot of interest in tech stocks at the moment.

A day does not go by, it seems like, to me at least, when I am driving in to work, that I do not hear on the radio the latest news on Facebook, Yahoo, Microsoft's search for a new CEO, Twitter's IPO, I mean, it is just all over the news.

A lot of our subscribers have been asking about it. In fact, earlier this year, we began an interview series with a tech sector expert, originally with the intent of just providing some additional coverage for our Wealth Society members.

Over the course of doing that interview series, we realized we had a huge asset in the person of Leo Boeckl, and we wanted to be able to continue to help our subscribers invest better in the tech market. A couple of months ago, we decided to launch a new publication based around his kind of unique approach to evaluating tech stocks.

Steve Halpern: Now, in analyzing stocks, you use a proprietary valuation model that he developed called the BIQ. Could you briefly explain how this works?

Jim Pearce: Sure. The BIQ is spelled B-I-Q and it stands for Boeckl Innogration Quotient, and, of course, Boeckl is Leo's last name.

Innogration is a term that no one knows, because Leo invented it, and I will explain what that is in a second. It is really a model that puts a numerical value on each individual tech stock we cover, based on the three specific elements of Leo's approach to evaluating tech stocks.

Implicit in that is Leo's theory of innogration—and innogration is the combination of the two words, innovation and integration, and, in simplest terms, it is based on the idea that the leading tech stocks of today, and in the future, are those that not only innovate internally, but also use their resources to acquire functionalities from external sources to create a market-leading product.

He has identified three specific variables that contribute to successful integration and assigned a numerical value to each of those, so that the total value, it is a scale of zero to ten, so the highest the company could score, if it is was perfect in every category, is a ten and the worst, of course, is a zero.

I can tell you there are no zeros or tens, but there are some companies that are down in the one to two range, and there are some others that are up in the eight and nine range.

It is a very useful tool in sifting through all the noise in the market to really zero-in on those companies that, not only are popular today, but will be the market leaders in the future.

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Steve Halpern: Now this BIQ Index is only part of the procedure you go through. The next step in your analytical process is to determine whether or not a stock is at a fair value, what you call the “smart tech rating.” Could you help explain this metric?

Jim Pearce: Sure, and you are correct, the BIQ score is only half of the equation, because, of course, a company could be doing a lot of the right things, but it also can be already extremely highly valued, to where it does not offer a lot of upside potential as a stock market investment.

We take that BIQ rating and we then convert it to the STR, or Smart Tech Rating, by taking the estimated forward 12 months earnings for that company as a ratio of the estimated forward 12 months earnings for its sector.

For example, you might have a company that scores high on the BIQ scale, let's say, for example, it rates an eight out of ten, but if it is already trading, like some of these tech stocks are, at several hundred times forward 12 months earnings, it really does not make a lot of sense to commit new capital to something like that.

On the other hand, you may have another company that gets, maybe, just a slightly above average BIQ rating of maybe a six, that is only trading at half the forward 12 month earnings of its group, in which case, there is a lot more upside potential in the short to intermediate term, in that kind of stock. That is what we see repeatedly in the tech sector. Companies become popular; they zoom way up in value.

Think of Apple (AAPL), a year ago cresting at, about, $700 a share, and then less than six months later bottoming out at $400, there is, kind of, this boom and bust cycle with these very popular tech stocks. What our system is designed to do, among other things, is help investors avoid getting up in that boom and bust cycle.

Steve Halpern: Let's walk through some examples of how the BIQ and the Smart Tech Rating work together. First, on the negative side, you cite Amazon (AMZN) as an example where this combination of indicators suggests the stock is overvalued. Could you explain that?

Jim Pearce: Sure. Amazon, in fact, is a great example of, sort of, this boom and bust cycle, based on what is trendy at the moment. Amazon possesses a lot of, so-called, shiny metal, in terms of things that make people interested in the company and therefore the stock.

Jeff Bezos was on 60 Minutes last week, talking about having drones delivering packages. There was also a report the other day, about how they will convert their warehouses to being fully robotic. He also, not that long ago, purchased the Washington Post, which also just got him a lot of press coverage, so it is a company that is very popular.

In fact, on our BIQ scale, though it has a very average BIQ score of 4.2, which puts it in the middle, which is okay, but then you have to look at its relative valuation.

Right now, Amazon is trading at about 150 times forward earnings, compared to a multiple of about 23 for its peer group, so it is already trading at six to seven times forward 12 months earnings what the average company and its sector's trading for.

Now that does not mean that it is about to crash, but to us, it suggests a company that has gotten ahead of itself, that, if there is any bad news, it could very quickly drop and drop very substantially. That is one that we actually are advising our readers to avoid and to avoid putting new money into.

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Steve Halpern: Now let's look at Oracle (ORCL), where your analysis and strategy suggests that the stock is undervalued. Could you walk us through that?

Jim Pearce: Sure. Now Oracle is an example of a company that does not have any shiny metal. Everything Oracle does is pretty much invisible to the user.

They develop a lot of application software, particularly for cloud computing. We all benefit from that, but that is not something you can take a picture of and show on the six o'clock news. There is nothing cool about that, from a trend following standpoint, but it is a very solid business that is just going to continue to grow significantly for years to come.

Now their BIQ score, coincidentally, is virtually identical to Amazon, it is a 4.1, whereas Amazon was a 4.2, however, it is only trading at about 12 times the estimated future 12 months earnings, compared to its sector multiple of about 25. In other words, it is only valued at about half of its peer group, even though it pays a nice dividend—it is currently yielding 1.4%.

They have solid growth and cash flow. They are in an area that is going to be one of the long-term major categories in the tech sector for decades to come, so there is one we like a lot.

If you go to a cocktail party over the Christmas holidays, you will not hear a lot of people talking about Oracle. You will probably hear a lot of people talking about Amazon, drones, and robots.

But, as an investor, you know, you really have to step back and sift through a lot of the noise in the market and ask yourself, “Look, which one of these companies offers the greatest potential for upside and the least amount of risk?”

We just think a lot of these companies currently trading at hundreds of times earnings, and, in some cases, over a thousand times earnings, are prime for a fall. If the Fed begins tapering in 2014, or there is any other unexpected bad news, those will be the stocks that will fall the furthest.

Whereas, if you are buying into a company like an Oracle, that is already trading at half its market average multiple, yes it would probably drop some in an environment like that, but not much, and you are getting paid a dividend to wait while the market recovers.

Those will be the first stocks to jump up when the news does get better. We believe that our approach gives investors a tool to sift through the tech sector and really pick out those stocks that offer the best upside opportunity in the years to come.

Steve Halpern: Well, congratulations again on the launch of Smart Tech Investor and thank you for joining us today.

Jim Pearce: You are welcome, Steve. Thank you.

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