Friday, March 17, 2006

Think Twice Before Investing In Companies That Manufacture Memory Devices Or Other Electronic "Commodities"

SanDisk (symbol: SNDK), the market leader in the manufacture of flash memory market, has performed very well over the past year or so. Since July 2005, SNDK has risen from the low 20s to the mid-50s today. One of my friends was recently touting this stock to me and telling me I should pick up some shares. However, I had to caution him. Although I have no doubt that SanDisk is a good company and has been performing well recently, I am of the opinion that an investment in a memory manufacturer must be made only after careful consideration because the stock performance of such companies has been historically extremely volatile.

Another of my college friends invested in Micron Technology (symbol: MU), another big memory manufacturer, back in 1995 after it had fallen from a high of about $90 to a price of about $60 (these prices do not account for the 2:1 split that took place in 2000). My college friend was convinced that this was just a temporary dip that provided a good investing opportunity. My college friend, however, could not have been more wrong. Within months, the bottom fell out for MU as it steadily fell, eventually down past $20. The stock eventually recovered toward the end of 1996 and he sold at about $30, taking a 50% loss on his position.

What neither my current friend nor my college friend fully appreciated is that the business outlook for memory manufacturers can dramatically change in the blink of an eye. There are many different companies that manufacture memory and as far as consumers are concerned, the products of all of these companies are pretty much the same. In other words, there really isn't much brand loyalty (there is, of course, some degree of loyalty, but not much) among consumers when it comes to the purchase of memory products. As such, I consider memory products to be a kind of electronic "commodity." That is, as far as consumers are concerned, there's no major difference between the products manufactured by any of the memory manufactures - consumers primarily will purchase memory products based on price alone.

Therefore, it is extremely difficult and almost impossible to maintain a sustainable competitive advantage over any competitor companies in this field. As a consequence, if one of the memory manufacturers decides to cut prices in order to gain market share, all of the other players are forced to cut their prices as well. These inevitable price wars absolutely kill profit margins.

The point of this post is not to belittle people for investing in memory manufacturers. I have no doubt that there's a lot of money to made in them from time to time - if you look at the historical stock charts for SNDK and MU, you'll see some terrific periods of time where these stocks went up hundreds of percentage points during a short time span. However, there are also some horrible stretches where the bottom fell out of the stock prices. I don't claim to be an expert investor - I've certainly made my own mistakes as well. Although I've never directly invested in a memory manufacturer, I have invested in stocks in the disk drive sector, which experiences analogous problems. I owned shares of Applied Magnetics, a disk drive component manufacturer, back in the late 1990s and lost my complete position when it went bankrupt.

So the moral is that you should perform extra diligence before investing in any memory manufacturer (or any company that produces an electronic commodity).

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