Expensive Technology Stocks Offer More Peril Than Promise

SEATTLE (TheStreet) -- The first time I saw the movie, Napoleon Dynamite, I walked out of the theater before the final wedding scene. This caused me to miss Napoleon's brother Kip singing "Always and Forever" to his new bride, LaFawnduh.

The key line in the song was, "I love technology, but not as much as you, you see!" Kip found LaFawnduh "in a chat room," which indebted him to technology.

It seems the US stock market, as represented by the S&P 500 Index , falls in love with technology even when it is not finding LaFawnduh. The newness and wonderment associated with technology creates a disconnection with the purpose of a business. For the sake of our discussion, LaFawnduh is revenue which generates profit and free cash flow. It's important to remember that the purpose of a business is to meet an economic need and to generate profit for shareholders in the process.

It's hard not to noticed that lately clouds, eye balls, Tweeted selfies and technology of all sorts have become the stars of the show. Profits and free cash flow have taken a back seat to the excitement over what could be, but might never be.

In a way, Kip loves the possibilities of technology more than he loves LaFawnduh, the wonderful byproduct of his time spent with technology.

An extreme historical example might be helpful. In 1999, there was a public company called eToys. U.S. investors were jacked up about the untapped potential of the World Wide Web, though they lacked any evidence which companies would be mostly to survive and thrive. At that time, EToys had about $41 million of sales and was losing millions of dollars. Nonetheless, it had an $11.4 billion stock market capitalization near its peak.

Elsewhere in the marketplace, Toys-R-Us were posting $11 billion in revenue, annual profits of $300 million, yet could only muster a $2.5 billion market cap. As we know now, the stock market loved the possibilities of the Internet more than it loved profits and free cash flow (LaFawnduh).

Does the current affection for technology hint at a similar disconnection?

Amazon (AMZN) has revenue and revenue growth with little profit and little free cash flow in relation to its capitalization. Facebook (FB) has eyeballs (including mine), Twitter (TWTR) has tweeters (including Smead Capital), LinkedIn (LNKD) has users (including me). The question we ask is do they have profits now and in the future which will justify their current stock prices?

In other words, is there any chance of finding LaFawnduh via the technology? Can they make us "salivate" over existing and future profits and free cash flow?

Charlie Munger explained recently to Berkshire Hathaway Annual Meeting attendees that "competition is the enemy of competence." When asked how to determine whether you have competence, Munger said, "If you are 5'3" tall, don't try out for the NBA."

It seems to us that everybody wants to try out for tech among today's 15-30 year-olds all over the world. We see the primary problem with investing in cutting edge tech companies is the fact that there are possibly millions of bright, young software engineers who get up every day and seek to create new technology that will cause Kip to fall less in love with existing technology.

In our view, these young brilliant software and computer science experts are coming after the profitable tech companies and even coming after technology companies whose profits could possibly be a fantasy. The competition is challenging competence in both cases.

The latest fears about eBay (EBAY) and our long-duration ownership of the company reminds us of this dichotomy. EBAY loves to use technology, which is mostly created by somebody else, to facilitate e-commerce. This online commerce facilitator has massive revenue in their marketplace and PayPal dominates the online payments business. Together they generated enough revenue and profit in the last year to have $4 billion of free cash flow.

It seems from the face of it, that eBay is the envy of Amazon, Facebook, Twitter and LinkedIn because the company loves technology and the way it helps meet an economic need. Be here's the key: they love LaFawnduh (profits and free cash flow) "more, you see."

Experience has taught us that the best way to measure a moat is to see how well it stands up to a real test. A few years back (centuries in tech land) Google (GOOG) took a run at creating an online payments competitor to PayPal. It was reported that Google spent over $300 million and had all the muscle that a near monopoly in Search could provide.

Can anybody even remember what they called it? The overwhelming answer is 'No.' PayPal has grown much larger and is more dominant today despite Google's efforts to cut them down a notch. PayPal has 148 million registered users and gushes free cash flow. Is it any wonder that one of the companies which loves technology and needs to figure out ways to generate profit and free cash flow would hire the guy who ran PayPal?

My guess is someone at Facebook recognizes that you should love LaFawnduh (profits and free cash flow) more.

This article represents the opinion of Smead Capital Management and not necessarily that of TheStreet or its editorial staff. It should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

At the time of publication, the author may have held a position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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