Transformational Technology Stocks

by Jonathan Kolber

Venture capitalists are some of the savviest investors in the world.They buy into early-stage companies, usually high tech, before the rest of the world knows about them.When they win, they win big: they can make hundreds of times their money on a single investment.

Although VCs are aggressive investors, they’re also careful.They perform extensive due diligence.They focus on savvy management, strong business plans, and really valuable technology with proprietary barriers to entry.

There’s a niche opportunity where you can do better than a venture capitalist.These are small public companies that VCs originally backed when they were still private.They went public, but they got into trouble somewhere along the way.

These companies can be better for at least two reasons, sometimes three.First, they are publicly traded, which means you can buy and sell them any time.Venture capitalists typically must hold their investments for five to seven years.(It’s still best to plan on holding these for years, not months – but sometimes you may unexpectedly need the money.)

Second, the due diligence process is more complete and more reliable because the small public companies are bound by Sarbanes-Oxley.This recent federal law mandates that small companies who lie to investors risk jail terms for their officers and directors.Thanks to Sarbanes-Oxley, you can rely on information in companies’ SEC filings, which is far more extensive than what VCs typically get to work with.

The third advantage is that these companies are often less expensive than when they were private.Having had their wings clipped by a bad event or two, they are no longer such high fliers. Their market capitalizations are lower.However, the potential is often still quite exciting.

Here’s the key: Many times, the stumble was not due to bad management but rather something external to the company.Often, this is something that doesn’t affect long-term prospects, but just the current quarter.(I call this “market myopia.”)

In particular, I look for the little undervalued public companies I call “transformational technologies stocks.”

Transformational technologies stocks are those capable of changing the world in some area.They don’t offer a marginal improvement to the status quo.Rather they have the potential to overturn a whole industry.

Transformational technology stocks have three stages of life, kind of like a butterfly.

During the first, or “caterpillar” stage, they wander around, but don’t seem to make a whole lot of financial progress.In this stage, they take in money from professional investors (usually, venture capitalists) and spend it on research and development.They burn through a whole lot of money, and rarely manufacture or sell anything.Such companies are subject to the vagaries of the stock market, and also to any news about them, whether significant or insignificant.

It’s best to buy these stocks during caterpillar stage, because no one can know when the next stage will start, or how fast it will unfold.

During the second or “cocoon” stage, the company is starting to succeed.It’s “cocooned from the broader market.”Its revenues grow rapidly, as it begins to sell products and moves to overturn an established industry.Constantly, the market capitalization and stock price rapidly increase.

In cocoon stage, price movements don’t have a lot to do with the broader market.During this stage, transformational technology investing is an ideal diversification from other types of investing.It offers a kind of diversification that’s unique.

Finally, during “butterfly stage,” the company is discovered.It becomes front-page news in the mass media and moves from outsider to mainstream.(Genentech is an example of a company that made this transition in recent years.)

Butterfly stage is the ideal point to sell.At this point, the most rapid price appreciation has already happened.Remember, every Fortune 500 company of today was at some earlier time a revolutionary.Transformational technology investing is about finding those revolutionaries early.

The Daily Reckoning