Profitless prosperity is tech's Achilles' heel

By Bill Fleckenstein

Profitless prosperity. It's a state often found in technology, where these wonderfully innovative companies that make our lives so much more pleasant wind up unable to make any money. In "Buy and hold can mean buy and lose," a column I wrote two years ago, I discussed what causes this dichotomy: the absence of a barrier to entry:

"Folks need to think about businesses they own from a competitive standpoint. In other words, what is the barrier to entry in this business? Very, very few businesses have barriers to entry. Not having a barrier to entry means that if you have a decent profit margin, you will be subjected to intense competition. One of the dirty little details that's never discussed on Bubblevision -- or by many of the perma-bulls, is the fact that a lot of businesses don't have barriers to entry, and paying historically high valuations for them is basically a recipe for disaster."

Obsolescing one's products

And that is the major problem with investing in technology: As wonderful and as complex as the products of these companies are, they are in industries that almost never have any barrier to entry -- especially since the general business plan is one of constant innovation, thereby obsolescing one's own products. (In other words, every company competes with itself!) The net result: Investing in technology is often very dangerous.

That fact, however, has been difficult for average investors to understand. The reason? Their views of what investing in technology might be like have been distorted by the big technological changes that occurred in the mid- to late 1990s (i.e., formerly room-sized computers now the size of an Etch-a-Sketch; cell phones; and the Internet) -- and by the huge upside moves that stocks enjoyed during the mania. Also, average investors seem unable to understand that just because a company makes a product they love doesn't mean it's a good investment.

Malaise at the mother of online malls

What brings up this little sermon? Last week's results from Amazon.com (AMZN, news, msgs). While not a tech stock per se, it illustrates the point perfectly. (So could hundreds of other companies -- such as Intel (INTC, news, msgs), where even a monopoly proved temporary, though the business was negatively impacted by horrible top management.)

Amazon is able to generate a couple of billion dollars per quarter plus or minus, but it's unable to bring much to the bottom line, which is the definition of profitless prosperity.

Neatly bundled numbers for the masses

The concept of a barrier to entry and what it means for profit margins is one of the most fundamentally important components of successful investing. (The most important component? The price you pay for an investment.) However, as mentioned earlier, I almost never see it discussed anywhere. Yet, since investing is supposed to be about seeking out profitable companies that have high barriers to entry and/or strong growth prospects at a cheap or reasonable valuation (assuming we're not discussing gaming the business cycle by buying cyclicals), it should be the first thing discussed, rather than the nonsense that passes for investment discussion these days: whether XYZ won or lost at the game of "beat the number."

This absurd little game really has nothing to do with investing. And most of what transpires these days is also game-like, as 10,000 hedge funds plus or minus battle it out with each other, along with various and sundry mutual funds doing the same. Which is not to say that no investing occurs, because that would be a gross overstatement. But investing is only done at the margin, versus the nonsense that passes for investing. Over time, as the bear market does its job of repricing assets lower to attractive valuations, you can be sure that the decline in many of the business plans masquerading as businesses will be particularly dramatic.

As for my "roadmap" (and where it's directing my strategies) circa now: The market appears to be giving off unambiguous signals that it is in trouble. In my opinion, the recent action suggests an inflection point, whereby economic weakness and disappointments are getting the upper hand.

Being 'clever' gets the cleaver

Consequently, I have decided to change my operating procedure, as to how I run my short portfolio. By that I mean: To avoid getting trampled during this bear-market rally, it's been necessary to be clever and try to dance between the raindrops by always being quick to cover. I now think that being clever runs the risk of missing many moves. So, it's time for me to be more of an investor on the short side. This is the first time I will have taken that tack since the 2000-2002 period.

I'm not sure that this means anyone else should do anything differently, but what I'm trying to convey is how serious our problems are and how strong I believe the undertow is liable to be. To position myself, therefore, I have sold a large number of stocks in the last week.

In some ways, it's all one trade. The consumer is overleveraged. He has been able to live beyond his means, thanks to the housing bubble. Now that it has ended, we will see bad debt and weaker consumer spending. At some point, there will be corporate weakness as well. We'll just have to see whether my reading of the tea leaves is correct.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckenstein Capital Web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. At the time of publication Fleckenstein was long Intel puts, short Amazon.com and long Amazon.com puts.