Alex Daley: An Investment that Thrives, Even in a Weak Economy

(Interviewed by Louis James, Editor, International Speculator)

Ed. Note: In the economic turmoil of the last five years, a lot has transpired. World markets lost nearly half their value in the panic, but have since recovered - albeit only in nominal value, with a massive lost opportunity cost over that time, and inflation taxing the real worth of those gains. Yet, throughout that time, one market sector has done surprisingly well - rebounding quickly and decisively from market lows, and growing precipitously during the climb out of the hole.

That industry? Technology.

From market bottom to today's record-breaking Dow Jones Industrial Average levels, Alex Daley has been seeing us through the maze of high-technology investments - and doing so quite profitably, we might add. Today, we talk with Alex about what's happening in technology and whether that bull run has the steam to continue.

But before we begin, a brief announcement: For liquidity reasons, one of our analysts needs to sell some small positions in Isis Pharmaceuticals Inc. (ISIS) and Curis Inc. (CRIS), but will wait until subscribers first have an option to do the same if they wish. This announcement is to comply with Casey Research ethics and trading policies and does not constitute a change in our recommendation for these companies.

L: Alex, it's been more than two years since we last sat down for one of these conversations, and the world has changed considerably since then. Can you update us on how tech investments look in the current context?

Alex: Sure. I agree with the Casey consensus on the macroeconomic picture - that is, the direction the US dollar is headed, the US economy, and that of the Eurozone. Long term, government overspending is a limiting factor on economic growth. It will ultimately reduce savings, increase taxes, and generally continue to be a liability thrust upon society. We can already see the beginnings of that today. However, other than the momentary market panics that will ensue as a result of this, the trend for technology investments is very strong, and for the long term.

L: What makes you so sure?

Alex: Three reasons. The first is that at a time when companies are afraid to hire - as we've had for the last five years - technology tends to advance very quickly. Managers deploy the cash they have on hand in new technologies that reduce their need for human labor, streamline operations, and reduce costs. This has led to several of the explosive growth stories we've seen in technology over the last two years, such as Big Data.

L: As it happens, I was recently visiting a mine where I saw an elaborate and extensive use of robots and automation in the processing mill. It looked very expensive to me, but the mine manager told me the robots saved them tons of money; they never get tired, take no coffee breaks, and are immune to repetitive motion injuries - the one we were looking at moved 50-pound rock samples 24/7/365. I found it striking to see this use of technology in such a basic industry. I mean, lifting rocks is not something I associate with NASA - unless they're on another planet.

Alex: Absolutely. Robotics is an extremely high-growth field these days. This brings me to the second reason technology is such a robust, long-term trend, and that's the major investment that has gone on for decades in R&D. One set of companies in today's economy is hunkering down in the face of economic turmoil, cuts in government spending, and so on. That has investors in another set of companies - those that have been pouring money into R&D - stepping in with innovations that solve problems and cut costs. New approaches to old markets, from the mining robotics you mentioned to advances like software-defined networking and in-memory databases are finding not just acceptance, but rapid adoption, as larger and more established companies in all sectors seek ways to streamline operations.

If anything, this has actually accelerated since 2008; you can find dozens and dozens of new startups every day. Many of these are now in intelligent systems, data mining, robotics, and biological technologies like genomics research. All of these areas were previously hard problems to tackle, because of the sheer computational power needed. That has gotten so cheap today, even compared to just ten years ago, we can now do things on a practical - commercial - scale that weren't even imaginable a decade earlier. That's driving the best investments today, which lie in intelligent systems and deep analysis (and the discoveries they enable), increasing productivity while reducing labor.

L: What about fundamental research? Does basic science suffer at a time like this?

Alex: To some degree, of course. Whether it should be or not, the fact is government is one of the major funders of basic scientific research in the modern world, so there have been cuts. However, there are multiple factors still driving significant fundamental R&D spending at the corporate level. For instance, in pharmaceuticals - an industry with approximately $750 billion in annual revenue, the second- or third-largest industry in the world - there is a massive patent cliff now arriving and slated to continue for the next three to five years. Over these coming few years, the big players are set to lose hundreds of billions of dollars in revenues, as the patents on their old chemical drugs expire. That is driving many companies to invest in new technologies.

Both the established companies and hungry entrepreneurs have seen this coming, sometimes starting decades ago, and we've seen a massive investment in new biotech treatments that has accelerated in recent years. This has spread into genomics, lipidomics, proteomics, and really, a deep study into all the things people are made of in order to find new therapies. I can't overstate how huge this research effort has been.

L: That's interesting - not just because of the investment opportunities this implies, but because there's a silver lining: a lot of conventional medicines are about to become much cheaper... a flood of newly available generic drugs from India?

Alex: Yes, but it's not so simple. Not everyone has the knowledge or technical ability to produce these chemicals, especially to the high quality standards required for human use. Japan is a more likely source than China or India, at least in the near term - cheap labor is not the same advantage it would be in other areas. But yes, there will be a shift.

However, most of these drugs are not really cures for most diseases, but "maintenance" treatments that address some of their symptoms, such as pain. This is the so-called "small molecule" chemical approach of the 20th century. The 21st century approach is to understand how a disease works and work on its underlying causes.

The diseases that cost us the most money are long-term things like diabetes, heart disease, and cancer. Those three alone account for more than 50% of medical spending today, by some estimates. Thus, this is where the most biotechnology research is focused.

L: I understand they are making major advances - not just finding ways to treat cancer symptoms, but to cure the disease?

Alex: Well, yes, but bear in mind that cancer is not one disease. There are about 145 ailments that we collectively refer to as cancer or oncological diseases. There are tons of companies working on this. There's Seattle Genetics, which is working to make chemotherapy more targeted and effective; Curis, which is working on blocking biological pathways for cancer; and countless others. We've talked about both of these before, and both have proven not only to be advancing excellent technologies, but have been excellent investments as well.

The brute computational force and unique biological techniques needed to crack the genetic codes relevant to cancer has resulted in major advances in other fields of medical research as well. Cancer treatment is a multibillion-dollar-a-year industry. It's such a big target that the amount of research going on in the field is almost unfathomable. This has produced many breakthroughs, such as reducing the cost of sequencing the genome of a human being from about a billion dollars to about a thousand - while reducing the time needed for the process from ten years to about one day. This is a major improvement in the ability of scientists to study the mechanisms that drive life itself - and what can go wrong - at a core, chemical level.

L: Such as?

In our most recent issue of Casey Extraordinary Technology, we covered a company that's working on a disease called age-related macular degeneration (AMD). This is the number-one cause of blindness in seniors in the US, and millions of people around the world have it. Its pervasiveness is increasing as our population ages, and really, we have no effective treatment for it. We can slow it, but we can't stop it, and we certainly can't reverse it. We've picked one company out of dozens in the field that we think has a very good chance of really making a dent, particularly against wet AMD, which is the most common kind, by focusing on the lipids - the fat molecules - that are involved in the onset of AMD. Without the R&D investment into cancer and biologics in general, its work would not have even been possible. But with rapidly improving tools giving birth to new insights by the day, the pipeline of biological treatments like this one is growing dramatically.

L: So, despite the economic turmoil of the last few years, the money is still there for research, and progress is still being made - and investments in commercial application of these new technologies are working out?

Alex: Yes. What's interesting about this market, though, is that it's your big, established players that struggle the most. This is not an environment in which to be jumping into the big companies that have always been there in the past - this is to say you should not be index investing right now. Instead, you have to focus on companies that have demonstrable revenue growth locked in. For example, while Microsoft and Intel have been struggling, Apple, over the past five years, has been a stark contrast. However, as a rule of thumb, the biggest companies suffer the most during hard economic times, as they have the most to lose. And when the markets are at all-time highs, like right now, that poor performance will be reflected more in share prices than when all boats are rising, like in the period following a secular low. So, when investing in the large caps, now is the time to be choosy.

Those same hard times, however, are nothing less than great opportunities for the startups that have new, better, faster, cheaper ideas.

L: For example?

Alex: Oracle is really struggling right now. A slew of new Big Data companies have been very successful selling more economic solutions to the data problems Oracle was handling for decades. These little companies are doing it cheaper, faster, and with a better interface that's accessible to business people. These products take analytics out of the province of nerds, if you will, and put it into the hands of executives, marketers, and everyone else.

Microsoft is struggling with the smartphone revolution, and Dell and Hewlett-Packard are suffering from the shift to tablets and more mobile computing. The personal-computer industry has, for the first time ever, shrunk, as governments, businesses, and individuals have held off on repurchases. Again, we see the big players affected the most; the majority are worse off than they were five years ago.

However, at the lower end of the technology food chain, at the startup or junior technology level, there's much more market opportunity. The amount of venture capital such companies have been able to raise and the amount of research they've been able to conduct has been virtually unaffected by the economic downturn. If anything, it has allowed them to grow faster - and given them more reason to.

L: I am again struck by the parallels between what you're describing and the junior resource sector I focus on. Rising costs hurt the big producing companies, but don't change the enormous addition of value shareholders see when an exploration company goes from having nothing to making a huge, rich mineral discovery. A tech startup also goes from having nothing to having a solution or improvement people need and will pay for - all the more so in hard times.

Alex: Yes, precisely. And unlike, say, a company searching for oil or copper, there is no commodity price fluctuation that's going to drive the stock one way or another. And if a company does "discover" a new technology, it doesn't run out when they mine or pump it all out; it can continue paying dividends for years and years. At the end of the day, they are turning intellectual capital into a product or service, which, if successful in the market place, returns financial capital on their investment. They are literally inventing value, and that's largely independent of the vicissitudes of broader markets. That's how some of the more successful technology companies - Apple, Microsoft, and so on - have returned tens of thousands of percent gains for their early shareholders.

L: I hate to admit it, but most tech also has the advantage of being perceived as cool - if not actually necessary and beneficial for society - whereas mining is a dirty business increasingly unwelcome just about everywhere. With the possible exception of military research, tech companies are in greater harmony with the modern ethos pervading society.

Alex: Even military research into new technologies can have that same kind of social approval and acceptance. Outside of the big defense contractors like Raytheon and Lockheed Martin, the companies that are doing the best in military tech are the ones focused on getting human beings off the battlefields and out of harm's way. Things like using robots to disarm explosives, survey the sea for submarines, or fly over hostile territory are seeing massive investment from the military these days.

But it doesn't stop there. The military pays for research and may or may not use the results, but there are often commercial applications of the same technology that make our lives better and safer - like the mine robots you saw. The software for self-driving cars is another good example - those self-piloted Google cars use software developed by the military.

There is certainly something to be said for the overall positive impact of technological development on society, though, of course, there are always prices to be paid. For example, as we move to more and more automated and robotic systems, there will be less and less need for manual labor. For example, Amazon recently purchased a company that makes robot-operated distribution warehouses - Amazon currently operates dozens of huge warehouses employing many people. For Amazon, it's the same as with your mining company; robots don't twist the wrong way and hurt their backs - and if they do, it's a two-hour service call, not a six-week workman's comp lost time incident. A social shift is coming, ready or not, when there is no longer a need for blue-collar work.

L: The world is changing, that's for sure. What was the third reason you mentioned when we started, the third factor that's going to keep the technology sector growing?

Alex: The third reason is precisely that change. New mechanisms for productivity help drive existing businesses to be more efficient, and that is always in demand - especially during tough economic times. And, yes, the last 20 or 30 years of R&D is really just starting to peek its head into the markets. Everything from robotics to genetics to artificial intelligence are just now making their way to true commercial viability.

The last five years of economic fear have created an innovation vacuum at the top of the tech stratosphere. This has opened opportunities for startup companies to seize upon the reticence of their much larger competitors - a gap early-stage venture investors pounced on aggressively. That is just now starting to show in public markets.

These three forces together have conspired to make an excellent environment for the more aggressive technology investor. Large corporations are either scrambling to find their footing or scrambling to buy companies that already have. Gone are the days, for the moment, of mega-mergers and goliaths stomping out the little guys. For the time being, nimble little mice are running circles around the scared majority of elephants. You can see it with the emergence of software-defined networking, which is threatening the Internet's big plumbing providers. You can see it with tablets wreaking havoc on the PC makers. And with Big Data.

L: You keep mentioning this "Big Data" phrase - which I hear a lot in the news lately too. Can you elaborate?

Alex: It's about mining the enormous quantities of information companies and organizations collect all the time. Traditional "row-based" databases have been the standard since Jim Gray invented the relational database in the 1970s. That technology hasn't changed in a major way since that time - until recently. The explosion in processing speeds and implosion of data storage and retrieval costs have completely changed the way we can do data calculations now. It's not actually one technology, but several that have come together, driven by companies like Google with mind-bogglingly huge datasets.

Formerly proprietary stuff that Google used to keep behind closed doors has turned into open-source code that enables many businesses to harness the richness of the data they have accumulated, for the first time, really. We're talking truly in-depth analytics that enables companies to more fully understand just about any trend or problem facing their business. This is, again, bad for the likes of Oracle, SAP, and Microsoft, but it's been a boon for startups. Technologies like Hadoom, column-oriented databases, and in-memory databases, among many others, are all shrinking the time and skill required to garner insights from massively large databases.

L: Example?

Alex: The most important applications are on the fundamental level of analyzing and understanding a business. For example, if you're an accountant trying to go through millions and millions of reimbursement receipts looking for fraud - or suppose you're a research scientist trying to go through the gigabytes and gigabytes of data generated by taking even a handful of human genomes, looking for similarities among people in order to pinpoint the causes of certain diseases. Either of these tasks is incredibly data-intensive - the sort of thing that used to require a supercomputer to be able to tackle. Today, those searches are much, much faster, and can be done with relatively cheap, off-the shelf hardware bolted to a rack.

We can now take on almost any kind of question. Retailers are looking for patterns in what kind of products to put next to each other on the shelves of their stores to increase sales. Zara, for example, has been a smashing international success in the clothing retail business, based partly on its sense of fashion, but also on the use of a fantastic inventory-management system. This has made Zara's founder one of the richest men in the world, rivaling even Carlos Slim.

This is what Big Data can do for you, and as data analytics get faster and cheaper, we're going to see more and more mining of this data to drive productivity, marketing, etc.

L: This may be an aside, but isn't there a Big Brotherish side to this? You couple Big Data with the proliferation of cameras throughout the world, and it's a bit frightening.

Alex: You know, people said the same thing about the advent of the automobile, which was very bad for the horse industry... and airplanes - people were never meant to fly!

L: [Laughs] I've been called many things, but never a Luddite!

Alex: [Chuckles] We all become Luddites in our own time. That may be the one lesson the steady march of technological progress has for us, despite all objections. But yes, you're right; as the ability to process massive quantities of data in real time increases, the ability of people to apply that to spy on others increases dramatically.

In the last election, both the Obama and Romney camps were talking up their use of Big Data approaches to analyzing and managing their campaigns. We're just going to have to get used to the fact that modern life produces reams of data about us each, individually, and that is going to be analyzed and made use of.

On the plus side, it also means we'll have smarter systems - better traffic management, for instance - and more individualized products and services. Imagine if TV became as relevant to us as Google search results. There is nothing technological stopping cable companies from delivering targeted ads via all those millions of set-top boxes. If they can use your data to show ads you're more likely to respond to, then they can show fewer ads and charge more for them. In that scenario, the cable company can make four times as much money with half the ads, which improves its bottom line, produces better results for advertisers, and results in a better viewing experience for the viewer. Win-win-win.

Retailers, restaurants, car companies, doctors, and so on will know our individual needs and be able to serve us better. Good with the bad.

L: I just hope I won't have to have my eyes surgically replaced to avoid unwanted advertisements or invasive government interference, like in the movie Minority Report. But okay, I get it. So, with all of this going on, what are your favorite tech investments today?

Alex: With the S&P 500 having reached the level it has today, the most important thing to remember is to cherry-pick the best companies.

Contrarian investments work very well these days, such as companies with strong fundamentals that are out of favor with the market. For instance, we recently opened and closed a position in Hewlett-Packard in six months, a very successful investment in our new BIG TECH newsletter.

With so many stock prices at multiyear highs and breaking through to higher levels, you have to be very careful. You can't just buy the index and hope to come out well. By being a contrarian in a market this frothy - which tends to overreact to both positive and negative news - you can make a lot of money.

L: With so many stocks riding high and so many business models becoming obsolete, do you ever recommend taking short positions?

Alex: We don't have any short positions in our letters today, but I think we're on the cusp of doing so again. We've had success with such plays in the past when we've seen bubbles form.

But back to my point: you have to be a contrarian regarding the big companies, thanks to the bubble forming in large-cap investments, but not so much for the smaller ones. There are so many, no Wall Street analyst can follow them all, so there are many that have escaped the hype. By being intrepid detectives, we can find great companies before the big guys have caught on. You want to be there before their revenues start to rise. That's where we make our biggest wins, the 100%, 200%, or 300% gains.

L: Sounds like what I do, applied in a different world.

Alex: It really is quite similar, in many ways. Any investor who finds himself or herself at home with the junior resource sector should do well in the tech sector. In any speculative market like that, it's all about separating signal from noise. That's what we do here at Casey Research, in all our different divisions.

L: Very well, then. Makes sense to me - thanks for the update. As I mentioned in Monday's Daily Dispatch, investing in more of your picks is definitely on my to-do list this year.

Alex: You're welcome. I'll do my best for you.