TMT in 2Q12: Investing for a Three Platform World

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In the three months since our last portfolio update, Apple and Google shares have risen more than 18% apiece, while the third and least established platform player Microsoft yo-yoed up and down before ending on a relative high note, up roughly 7%.  As TMT investors pick sides for the emerging three-way battle, we continue to believe that the opportunity is more than big enough for all three to prosper and that each has a unique position of advantage and a distinct business model in which to root their success.  Indeed, platform competition offers anti-trust air cover that may allow platform leaders far more leeway to concentrate value from the massive paradigm shift than had been available to Microsoft during the salad days of the PC.  Against this, trillions of dollars of the economy will be disrupted by new devices, e-commerce, on-line advertising, streaming media, mobile payments, consumer services, on-line education, Internet medical consultation, cloud hosting, Software-as-a-service, and other products enabled by the new paradigm.  We believe that the big three, along with companies well aligned to their future dominance, will disproportionally benefit from this.  Along these lines, we are making modest changes to our model portfolios to reflect our evolving perspective on those beneficiaries.

We see platform owners as the primary beneficiaries of the generational paradigm shift underway in the TMT landscape.  Our previous quarterly update reviewed our general thesis of massive disruption of traditional IT and consumer media by portable devices, wireless networks and cloud-based services. In this once a generation sea change, we believe that Google, Apple and Microsoft will leverage their platform control to consolidate a disproportionate share of the value being created.  We also believe that the platforms of the previous era – i.e. PCs, Cable TV, Client-Server IT, etc. – will be displaced more quickly than most observers expect.

The opportunities created by the shift will grow to be worth trillions of dollars in annual revenues over the next two decades.  The industries sparked by the ‘80’s shift – PCs, wireless devices and services, broadband, cable television, browser-based Internet, client-server hardware and software, etc. – generated $3.2 trillion in global annual spending, all of which is up for grabs again in the new paradigm.  At the same time, new opportunities in areas like e-commerce, payments, advertising, education, health care, and others portend considerable opportunity for growth beyond displacing aging platforms.

Microsoft, Apple and Google are attacking the market with very different business models, adding to the likelihood that all three will be successful in sustaining their platforms.  The three platforms proceed from different strongholds, with distinct weaknesses as well.  Apple makes its money on device margins, leveraging its extraordinary design and marketing skills, locking in users for future upgrades and new product categories.  However, it is a neophyte in distributed data processing infrastructure and cloud applications.  Google is strong where Apple is weak, monetizing its dominance in cloud technology through advertising, but struggling to coax its fragmented device ecosystem to follow its direction and fighting off IPR attacks.  Microsoft’s core business is enterprise software and it has the inside track as IT departments methodically move to the cloud, unfortunately it is very late to the game with consumers.  Amazon, which monetizes through e-commerce and has a powerful distribution mechanism for its fledgling platform, represents a fourth business model and the only real hope for an alternative to the big three.  These contrasts make the competitive conflicts less direct and reduce the likelihood of a winner takes all outcome.

We have bet on all three platform players in our Large Cap Model Portfolio, which continues to outperform the broader market.  Our Large Cap Model Portfolio was up roughly 12% since our last update on June 12, outperforming the S&P500 by more than 370bp for the quarter.  Google was the top performer, up 24.0% on strong 2Q12 results, with Apple up 15.0% over the same timeframe in anticipation of next week’s iPhone5 launch.  Investors remain somewhat skeptical of Microsoft, which underperformed with 5.2% appreciation, despite upside earnings and the pending introduction of its Windows 8 and Windows Phone 8 platforms.  This quarter, we are removing Priceline, which was a notable underperformer and faces growing competition, and SanDisk, which was a strong performer but could see decelerating demand going forward.  We are adding Akamai (AKAM), which will benefit from the strong growth of streaming video, and Seagate (STX), based on our bullish view of the cloud storage opportunity.

Our thesis is challenging for small cap companies competing with platform players – our Small Cap Model Portfolio focuses on components and differentiated services.  Our Small Cap Model Portfolio was up 7.2% since the last update, but underperformed the S&P 600 by 390bp.  We are removing three stocks that were notable laggards and only peripherally related to our core thesis – Comscore, Super Micro Computer, and Digimarc.  In their place, we are adding Brightcove (BCOV) which provides on-line video streaming solutions, Monotype Imaging (TYPE) is a leader in electronic fonts and text rendering, and OmniVision (OVTI) is one of two major suppliers of image sensors for portable devices.

For more full text, please see our published research archive.

 

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