Tech Stocks To Avoid

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site, is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

With Facebook’s (FB) lackluster opening trading, and subsequent fall below its initial offering price, is this a sign the tech boom is over?

Forgetting about Apple (AAPL), which has sold off by some 15% from its record high of $644 per share, and ignoring investors mixed welcome for the Facebook IPO, there are some real signs of trouble for the tech industry.

Perhaps no sector has done a better job at increasing profit margins through innovation and cost cuts. The technology sector as a whole has developed new ways to cut material costs and increase worker productivity.

For example, many chip makers are now using copper instead of gold as the primary circuit connectivity material; copper of course being a lot cheaper than gold, which has helped margins significantly.

Tech employees are also generating the most amount of output they ever have. In other words, technology companies are operating at peak performance. And with that lies the problem.

When efficiencies are at their highs, there are only two factors that will continue to increase revenues and profits–strong demand and even more efficiencies.

There is certainly no need to rehash the problems the world is facing visa vie Europe and the risks of a global economic slow-down. Digging deeper, specific to technology, we observe that capacity utilization for tech is down for the corporate sector. Meaning that companies can squeeze more productivity and use out of their existing technology–there is spare capacity.

In the absence of strong global growth, the drive among users to improve capacity utilization enables techs to keep growing their top line. Softer global demand and less utilization implies a rocky road ahead for tech companies.

This past quarter, Cisco Systems (CSCO), Auto Desk (ADSK) and several other large tech companies provided a muted and cautious outlook for the rest of 2012. Here’s some other data points:

Chinese wage inflation will impact profit margins. Since capacity utilization is down, there is little pricing power and company’s will have to absorb a large portion of these increased labor costs.
Hewlett-Packard (HPQ), in yet another effort to turn itself around, and others are laying off workers. This is not a sign of a thriving company or industry
Technology is evolving at a staggering pace. Just think of Blackberry, Dell (DELL) or Yahoo (YHOO). All were leaders in their fields and they are now struggling to survive. In an environment of rapid innovation, missteps are more likely and more likely to be fatal. (Historical artifact: Netscape; RIP: MySpace; On life support: AOL; Sickbay: Electronic Arts; Walking wounded: NCR)
As a result of these trends, I’m cautious on the tech sector.

We’ve recently sold our holdings in Akami (AKAM) and VMware (VMW).

We don’t own, and would recommend investors avoid Dell, Yahoo and Facebook.

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