FREE KIC - NO. 16 JANUARY 07

TECHNOLOGY SECTOR FOR THE LONG TERM INVESTOR ?

I used to talk to a stockbroker called Stephen Hay in Goldman Sachs. Stephen specialised in the Japanese market but one day back in about 1993 we were talking about his personal investments when he mentioned that he had bought shares in a couple of American analog semiconductor companies. He had done this based on the work of an analyst he knew. He said that the analyst had convinced him that as more and more devices became digital there would be a need for more analog semiconductors. The analyst also pointed out that there were major barriers to entry preventing competition eroding the returns of the leading companies in the sector. At the time I felt the last thing I had was the time to go off researching American companies when there was loads of work to be done on the Japanese market. Technology was (and still is) a significant part of the Japanese market so I was spending time looking at technology including digital semiconductor companies but because the Japanese were not a player in the analog semiconductor industry I never really had any opportunity to study it.

One day I was talking to another analyst about how difficult it was to cover the technology sector and he suggested that I should go to the American Electronic Association (AEA) conference because it would give me the chance to meet lots of technology companies in the one place and therefore it would be a very productive use of my time. I took this advice and flew off to Monterey, California in October 1995.

At the conference I decided to go and listen to Analog Devices because I remembered what Stephen Hay had said. At most of the other meetings I attended I was part of a group but it just happened that when I decided to visit Analog Devices I was the only person there. I was therefore in the lucky position to be able to ask all the dumb questions that you need to ask when you start off learning about a company or a sector.

I was told that the thing that makes the analog sector so unique is the fact that there is a global shortage of the people that design analog semiconductors and it is highly unlikely that there will be an over supply because it is as much an art form as it is a science. The leading designers tend to want to work for the leading companies and as long as the leading companies look after these scarce designers they will remain in a position to charge premium prices for their products.

I was also told that the sector was likely to grow over time. As electronic devices became more complex the analog content was likely to increase. In other words we had a growth industry where the leading players were in a strong position. The growth of the industry is shown in the picture below:

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The story I heard from Analog Devices back in 1995 sounded very interesting but the unusual thing is that Analog Devices and all the leading analog semiconductor companies tell the same story to this day. The evidence I have seen suggests that the story remains basically intact.
It sounds pretty good to me but is it possible that I am missing something? Is it possible that thousands of designers are just about to emerge from Chinese, Korean or Indian universities and will undercut the existing players?
From 1995 to this day I have asked this question of anybody who may know the answer. I have asked a number of people that work in analog semiconductor companies and I have asked lots of analysts and I keep hearing back that there is no dramatic increase on the way. I think that the Chief Financial Officer of Linear Technology, Paul Coghlan, gave me the best answer to the question. He said that a number of fund managers had visited him one day and one of them asked that very question. Before Paul Coghlan had time to answer it another fund manager said that his father had been an analog designer and had become wealthy because of it. He said that he decided that he should also become an analog designer and become just as wealthy so he studied physics in university. In University he was given the opportunity to try and make a very basic analog circuit but he just could not stop it oscillating. In other words he suddenly realised just how difficult it is to be an analog designer so he became a fund manager instead! All the evidence that I have found backs up this idea that designers are in short supply and it takes ten years to train a good designer.

If designers are in such short supply is it also possible that the designers will make all the money and the companies will be forced into a situation where they compete away their profits as they pay more and more to attract good designers? This is obviously a concern and the answer I have got to this question is that the leading companies appear to have got themselves into an entrenched position that is hard to penetrate. In other words all the best aspiring designers want to train under the currently recognised great designers and therefore aspire to joining the established leading names.
The leading names in the time I have been covering the industry have been Linear Technology and Maxim Integrated. Not far behind these two have been Analog Devices and the analog division of Texas Instruments. There is then the next tier of companies like Intersil and National Semiconductor.

History appears to support this idea that the profits of the leading companies will not be eroded by smaller companies stealing away the best design talent. The table below shows the operating margins of the leading companies for the last six years :

 Margin 010203040506
Linear56.243.948.654.156.256.6
Maxim38.633.738.843.346.744.0
Analog23131926.622.926.2

This is the evidence that proves that this is a highly profitable business and also supports the idea that profitability has not been eroded over time.

I personally bought a small number of shares in Analog Devices back in 2001 because at the time this was the company in the sector that I had the most familiarity with.

The chart below shows the Analog Devices share price going back to 97.

graph

As the chart shows it was poor timing to buy in April 2001. I often say that I am buying shares on at least a 5 year view and possibly even longer. (As I mentioned in last months opinion piece I have owned ASM Pacific shares for over 10 years). Even I have to admit that my timing was awful. I have lost money on a 5 year view and only time will tell whether it will turn out better on a 10 year view.
So why has the share price gone down since I bought in 2001 when this is a good company in a growth industry? I think the simple answer lies in looking at the valuation that investors are prepared to pay. I thought in 2001 that investors seeing the attractiveness of this industry would continue to pay a premium valuation. At the time I think the consensus was that Analog Devices would earn about $1 per share in the year ending Oct 01. As I paid $41 per share I was buying on a Price Earnings multiple of 41x. I thought that earnings would increase and that investors would continue to pay at least 30x earnings and maybe even more.
In the year ending October 06 Analog Devices had earnings per share of $1.63 so I was right in terms of earnings growing but I was badly wrong in terms of what investors would pay for those earnings. At the current share price of $34 investors are only prepared to pay 21x earnings. This is still a premium valuation but a much smaller premium than in the past.
In October I bought more shares at $29.5 when they fell to a valuation of about 18x earnings. I just felt that this company should sell on a premium given its characteristics. Time will tell whether I am right this time. It is quite possible that something will happen to bring down the valuation even further.
I feel I have learned a valuable lesson having bought the shares back in 2001. I feel as if I will be really reluctant to pay a big premium for any share in the future. (That is why you are unlikely to see me recommend Google and maybe it is part of the reason why I would be nervous about investing in the Irish property market at current valuations.)
Warren Buffett constantly points out that you should always buy things on the right valuation. Maybe I will end up writing another opinion piece in years to come pointing out why I should have waited further before buying again. Time will tell.

I also bought some Linear Technology shares in October at $31.48 per share. Will my timing be better in this share?

graph

Linear Technology had results on January 16th that disappointed the market. The company is blaming the disappointment on inventory reductions at their customers. Some analysts believe that the company is facing far greater problems than just an inventory reduction cycle. These analysts seem to believe that they are losing market share but so far I believe that the evidence is inconclusive. I am therefore putting my faith in Paul Coghlan because just as I said last month that I really warmed to Patrick Lam of ASM Pacific I also warmed to Paul Coghlan.

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I am taking comfort in the fact that Linear is hiring new designers, building new design centres and adding production capacity. These are not the actions of a company that believes that they have a problem. These are the actions of a company that believes in its future.
In conclusion I have to admit that only time will tell. I have put my money where my mouth is and I will keep you up to date on progress.

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Directors: Kenneth Power (Managing) B.Comm, MBS, ASIP, Regular Member of the CFA Institute.
Siobhan Power