Understanding The Technology 'S' Curve

Includes: AAPL, AMZN
by: Dana Blankenhorn

Technology investors want to anticipate growth. It's more important than growth itself.

Once products mature and become highly profitable, measure tech against any other industry.

Get in front of the "S" curve.

If you don't understand the "S" curve, you should not be investing in technology.

The "S" curve describes how supply, demand and profit work in a fast-growing market. Profits are highest when the market is young, when a product is just entering the mass market. Once most people have the product, profits per unit slump.

This is why technology investors prioritize growth over gross profit. Profits earned after a product is mature will be discounted to the value of what companies outside technology are earning. But margins early in the product's life cycle will get a premium price, as investors anticipate growth.

This is why technology companies must continue to innovate in order to earn a premium price for their stock. Once their markets are seen as saturated, the stock falls to Earth.

This also means that a reputation for innovation, and for creating new markets, can be as important to the technology investor as both profit and growth. It's the anticipation of growth that is most important, and that commands the highest premium.

Thus, Apple (NASDAQ:AAPL) earned its highest valuations in the years just after it delivered the iPod, the iPhone and the iPad. Once investors saw the size of those markets, they began to discount the shares, demanding they perform just like those of a car company or airline. It did not really matter what Apple did to "value" shareholders - buying back stock, splitting the shares, or paying a dividend. What mattered was that the markets it had created were saturated. For the shares to gain traction, Apple must be seen to be creating some vast new market, an opportunity comparable to the existing company. A Watch won't do it. A car might.

Amazon.com (NASDAQ:AMZN) by contrast is seen as having a long "runway" for many of its innovations. We are still in the early years of the cloud market, and Amazon is the market leader in cloud infrastructure, by a lot. The "bot" era of software-hardware combinations that interact more naturally with people and more automatically with their things is part of the Amazon Echo and that has barely made a dent in the mass market.

Thus, the reputation for innovation and for producing huge opportunities that are at the start of the "S" curve rather than the end carries Amazon's stock forward. Actual profits matter less than gross margins. Margins are re-invested directly in order to create new innovations. Technology investors like that.

If you are complaining that "Amazon doesn't make any more" or "Apple is undervalued," in other words, you just don't understand the "S" curve, or you disagree with its premise. You should not be investing in technology, but evaluating all types of investments in the same way, seeing airline profits, car profits, and technology profits in the same light.

There is nothing wrong with this. Seeking dividend income can be a good thing. But it's not the way the technology market works.

Disclosure: I am/we are long AMZN, AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.