The gut check

image: Wikimedia commons.

The term "gut check" usually refers to the idea of testing resolve, assessing the level of conviction to press on to the goal even in the face of increasingly difficult conditions. 

Militaries around the world have devised various ways of creating "gut check" scenarios: one such "gut check" that we remember hearing about, which was used in the training of candidates for a certain special operations unit, involved a long and difficult road march carrying heavy gear towards a designated point, where participants were told that trucks would be waiting to take them to the next objective. 

When the hopeful candidates, after several hours of walking, arrived at the designated location, the trucks that they found there suddenly started up their engines and drove away, just before anyone could climb on board. The instructor then informed the candidates that they had to move on foot several more miles to meet up with the trucks. 

Many of them threw their rucksacks on the ground and declared that they were quitting right there. What they did not know was that the trucks had only driven a few hundred yards over a ridge and around a bend, and that if they had just pressed on for a little ways their long march would have been finished successfully.

There is an old saying in the investment world that "guts" are in some ways more important than "brains." Certainly, analysis and research are vitally important in finding good investment candidates, and in evaluating those investments and deciding whether or not to commit capital to those investments. But those who have been at this business for any significant length of time will know that the markets have a way of delivering "gut checks" that are every bit as mentally challenging as the truck scenario described above -- and if an investor does not have the "guts" to persevere through those periods of testing, no amount of "brains" will matter.

Investors in the systems which enable the interconnected, mobile networks of the modern world are presently experiencing a real gut check right now -- some might argue that they have been experiencing a gut check for the past few years.

Yesterday, for example, network processor company EZchip, which we have written about in the past, announced that their revenues for the current quarter would be about 10% lower than they had predicted -- an announcement which contributed to the overall negative sentiment in the sector of companies offering solutions to the carriers whose data centers and towers and nodes move the data and enable the mobile networked activity that consumers and businesses use every minute of the day.*

The selloff in EZchip was immediate and significant, with the stock dropping about 10% in one day. It was, in an sense, a "gut check" for investors who thought that "the trucks would be here by now," so to speak -- and many investors (including some who may have invested in EZchip for many years) threw their rucks on the ground and said they were done with it. In other words, they sold their shares.

We bought more.

The reason we bought more in this case is that, while we don't know exactly how much further we will have to go before the situation suddenly gets better, in this situation we are absolutely convicted that the situation will in fact get dramatically better. 

The conditions that investors and industry participants have been talking about for years have not changed: the demand for more and more data, delivered more and more rapidly, and at higher and higher levels of sound and visual quality and resolution is growing exponentially, and the infrastructure to deliver all of that data at higher speeds and higher levels of quality has not been keeping up, and will necessarily have to be upgraded. 

This fact is no secret in the industry: it is the focus of nearly every company involved in the networking world. The carriers are facing billions of dollars in spending (actually, tens of billions of dollars in spending) and we believe that they have been evaluating their options and weighing their deployment of so much business capital very carefully over the past several years. 

At the same time, many new transformative approaches to the underlying problem have been developed, including the industry-changing approach known as NFV, or "network function virtualization," which has radical implications for the makers and buyers of network equipment and for the designers and architects of data centers and data networks. In light of this fact, it is to us no surprise that the carriers want to thoroughly evaluate the situation and look at all of their options prior to committing to courses of action which will involve billions and even tens of billions of dollars.

We believe that this process has been going on for some time now, and that it is still going on -- but we also believe that it may be nearing an end and that the move may begin to take place very soon. We don't know exactly when the evidence of this move will begin to be evident, but we are fairly certain that it will in fact happen. 

Obviously, this move will involve industry dynamics which are bigger than any single company or any single investment name, including EZchip -- we just use EZchip as a timely example in this discussion. We invest in other businesses which we believe are positioned to benefit from this same dynamic, not just EZchip, and we would advise other investors who want to benefit from these types of major industry paradigm shifts to follow a similar course. 

The bigger point is the concept of the "gut check." Many market participants are very short-term oriented in their focus, for various reasons (sometimes for very good reasons). For whatever reason, they simply cannot continue to march after the trucks, even if those trucks have only gone over the next ridge and around the next bend. When investors with a longer focus see others around them "throwing down their rucksacks," so to speak, and declaring that they are done with this road march, it can be very disconcerting -- and some investors may be tempted to do the same thing just because everyone else is doing it.

Please note that we are not advocating that investors never sell an investment, or that selling an investment when new information requires a re-assessment indicates some kind of failing: if the new information changes the investment thesis to the point that the original assessment is deemed to be no longer valid, then selling the investment may in fact be the right thing to do, and failing to sell it at that point would be the real failure!

But if, on the other hand, the original investment thesis is still valid, and it is the market which is being short-sighted and throwing a tantrum when the trucks drive on a few more hundred yards out of sight, the right thing to do may well be to press on. 

We believe that this may well be the actual situation right now in the networking solutions space, but we also believe that this valuable and important principle of the "gut check" is one that is broadly applicable in the business of investing -- and in life.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by EZchip Semiconductor (EZCH).

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