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Bottom Line: Hard buy, Soft sell

By GREGORY FOSSEDAL, UPI Columnist   |   July 24, 2004 at 2:26 PM   |   Comments

LOS ANGELES, July 24 (UPI) -- Last October, with computer companies seeming ready to enjoy a new surge of growth, "Bottom Line" recommended selling the stocks:

"Investors fishing for a few good shorts," BL wrote, should look to "the U.S. technology market," particularly those sectors where a challenge to the validity of intelectual property rights internationally make companies "vulnerable to the kind of domestic and international assault seen in, for example, the music recording industry....

"Smart investors are putting their shorts on the computer software sector, with a special emphasis on the pitiful, helpless giants such as Sun Microsystems, Oracle, and even Microsoft. Awash with cash and wishy-washy bureucracy that would have scandalized their founders 25 years ago, these are the giants that have the farthest to fall -- and will have the most difficult time dealing not only with emerging market piracy, but the more subtle assault of 'open source' software termites operating in the U.S. and Western Europe."

We reiterated that position in March, at which time clients also sold long positions in Red Hat, VA Software, and other small software service companies -- such as Sco Group, the Unix operating system provider that is a major competitor to and antagonist of the open-source movement. We saw all of these as benefiting from the confusion and unwarranted optimism about commercial applications of open-source software, and held many of them for more than two years.

"Open source," for the unwashed, is a loose grouping of individuals and companies that provide free software. Some of them are perfectly respectful of the intellectual property of others. Others are not, and indeed, speak with open contempt of the concept of respect for copyrights and for proper credit and attribution.

Software firms peaked in November and December, at which point our clients increased their short positions, and are little changed from October, down from March. It's an excellent short to hold on to, given the state of confusion about intellectual property in the long run, and the still-high valuation levels for the group.

The best short to make, whether in October or March, would have been on semiconductors, or hardware -- about which, "bottom line" was mute. These stocks are off better than 50 percent from their highs. They're now an excellent buy, particularly in combination with a short on the big software makers, for three reasons.

1. Prices have moved to a greater excess. Semiconductor stocks such as Taiwan Semiconductor are selling at un-tech-like ratios of less than 20-1 of backward earnings. Prices have declined in spite of surging profits and sales growth. Software firms, even the giants, continue to sell at much higher multiples. This despite the fact that many of them are essentially utilities just as much as the hardware firms.

2. People are still buying stuff, particularly the stuff, from ipod players to mobile telephones, that can do increasingly amazing things compared to even a year or two ago. Chips don't just go into personal computers any more. They're in our mobile telephones, entertainment devices, automobiles -- you name it. Fall back-to-school sales are already picking up, and should enjoy some unexpected upside as this summer's mild growth pullback proves to be anything but a double-dip recession.

3. Hardware innovations are protected by patents. This is critical in the long run. Unlike software, which must rely on copyright and other laws to protect intellectual property, the makers of stuff enjoy international patents. These, too, are violated, but are much more secure than the vast grey area that protects software programs.

The industrial barriers to entry to making stuff are much higher too, meaning IP theft is normally carried on by one of a finite number of identifiable competitors -- as against the army of termites that can borrow, rewrite, reverse-engineer, and, in rare cases, just plain steal software code. "There will always be some jurisdiction," as open-source "Muse" Eric Raymond writes in "The Cathedral and the Biazarre," where reverse-enginering is legal -- or laws against it, unenforced.

There is a buy in the software sector, in our opinion -- namely to cover short positions in stocks like Red Hat that may enjoy a trading rally in coming months. These stocks should, however, be a short again if they return to their pre-correction levels of the spring.

And "Bottom Line" still likes SCO Group, despite the lumps the position has taken in recent months. SCO is the one proprietary software company that is gamely challenging the hybrid-source, hardware-maker-led termite attack on intellectual property by suing IBM. Its chief counsel is sharp, tough, and has won nine-figure awards from Microsoft and others in the past; bet on IBM to settle, if it's smart, and lose a 10-figure judgement if it goes to a jury.

The bottom line is, buy hardware, especially non-pc chipmakers, and keep the shorts on the software giants. Cover your shorts on the open source movement for a last-gasp rally, but put the puts back on after a rally -- and stay in Sco group that has more than a David's chance of defeating IBM's Goliath.


Fossedal manages international investement research for Emerging Markets Group in Washington, DC. His clients may (and usually do) hold long and short positions in many of the investment securities and opportunities mentioned in his reports. "The Bottom Line" is compiled from sources we believe to be reliable, but no representation is made that they are necessarily accurate or complete. Investors should perform their own due diligence and consult their own professional advisor before buying or selling any securities. Mr. Fossedal's opinions are entirely his own, and are not necessarily those of UPI or EMG. Futhermore, they are subject to change without notice.

© 2004 United Press International, Inc. All Rights Reserved. Any reproduction, republication, redistribution and/or modification of any UPI content is expressly prohibited without UPI's prior written consent.
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