So JP Morgan announced a surprise $2B loss from “failed hedging” and joins the ranks of numerous failed trading strategies implemented by all the “smartest and best equipped teams in the world.” To channel Donald Rumsfeld for a moment we all know that the risks from the massive and complex derivative market are unknowable.

Warren Buffett famously warned that derivatives were like hidden nuclear weapons lurking in our financial system. Despite knowing all this we’ve seen bigger and bigger failures – culminating in the collapse of 2008. It’s a bad thing for our markets. As can be seen by the chart here (from PitchBook) the capital markets haven’t been the same for some time. Volumes have not come back into the markets. This isn’t good.

We’ve seen quite a few friends loose money in their self-directed investment accounts and also massively in funds like the “can’t miss” Goldman quantitative return funds where their few million dollars (minimums were high on those) literally went to zero. Friends shouldn’t let friends invest in quant funds!

Bringing this back around to the SoundView TechFund we continue to shine the light on how hedging and the penchant for smooth monthly returns is insane and impossible. It’s very old school but the modern practice of doing your work and buying low and selling high works very well when you invest for a year or more.

We are not a hedge fund in the sense that we try and remain market neutral. It’s likely that we will have some short positions from time to time but they are for fundamental reasons. That means that we will have bad months and good months. Having down months means that most institutional money won’t be interested because they are looking for funds “that only have good months.” (I’ll pause here so to enjoy the absurdity of it which never gets old for me.)

Sometimes our friends see the news about collapsing markets and kindly ask “are you doing okay in this horrible market?” To this we point out that if you have a plan then volatility is your best friend. We’re not going to lie and say it’s sometimes nice to see your portfolio have a great day, it is. But unless you are withdrawing your money the next day it’s just another point on the curve. The mission is to make sure the curve has a positive slope!

For example we had a rough April. Several of our positions were hit by heavy selling due mostly to “risk off” behavior and sector rotation into things like consumer staples and healthcare. During this time we are adjusting and increasing positions where there is the greatest potential return. LinkedIn (LNKD) has moved up substantially and while it still has more room we reduced our position from 7% to 3%. Qualcomm (QCOM) however has pulled back from $68 to $63 so we upped our 3% position to 6%. (Our LTIV on QCOM is $100.)

To love volatility you can’t be sleeping with leverage on the side. Using leverage blows up this strategy. We’ve seen this recently with Green Mountain Coffee (GMCR) which is not something we would ever own but we weren’t short either. There are multiple problems with this story but one that surfaced recently is that senior management borrowed against their stock positions. In other words they were on margin. When the stock started going down they were forced to start selling at lower and lower prices. When the smoke cleared the shares collapsed from $50 to $25 in a hurry. Being forced to sell low cannot be a possibility for your strategy to work.

Lastly we can hardly say enough about sticking to our intrinsic value (IV) process. It can be hard to do in the face of “great companies” that you “have to own” but that trade at very high valuations. This happens often in the IPO market as enthusiasm trumps analysis. One company we watch is Cornerstone OnDemand (CSOD). It’s a very good company but came public and began trading with a value of 21x sales. A multiple like that is so high we don’t even need a model to say that it’s way too expensive. A year later the shares are where they were then, $18/share, and the company is “growing into” that stock price. Today the price to sales ratio is 12-13x. That’s still high but getting reasonable. We have to build our model to know if this is a good investment now but we won’t own it if it’s not.

Right now truly safe investments like US Treasuries ensure that you will lose value due to inflation. There are some pretty safe yield bets out there that should generate 3-5% annual returns and if you have a one year or longer investment horizon you can exploit the market to get higher, growth-driven returns; not without volatility. But as we said… if you can learn to love it the benefits will last a lifetime.

Over the course of April we filled out our portfolio and eliminated our 14% placeholder position in the QQQ. Our new positions included:

Adobe (ADBE) – We have been waiting for the right moment to buy Adobe over the past year or so. The shift to “mobile first” development and rejection of Adobe Flash in favor of HTML and other toolsets knocked the company for a loop. However as we expected Adobe has been remaking their strategy and will be shipping the next version of their flagship product Creative Suite 6. This will be the first version available as SaaS. There is still some debate in the market as to what extent the monthly subscription option could cannibalize their core software and upgrade business but we see that as a distraction. Fundamentally Adobe has fended off any and all realistic competition for serious digital development projects. We actually expect the SaaS option to finally entice the reluctant to move off older versions like CS3 and CS4. A casual user isn’t going to pay several hundred or more than $1000 to upgrade to a new version. So the monthly option is perfect for them. It’s possible that some who might purchase could opt for the SaaS version but since this is generally “higher multiple” business from an investment standpoint we are not concerned about the potential mix shift. Finally Adobe shares at current prices are well below our intrinsic value (IV) estimate of $50.

Qualcomm (QCOM) – This is another well-known name in the mobile space. They have been executing extremely well and are one of those unassailable players in mobile infrastructure. With our analysis complete and a long-term IV of $100 the shares justified an initial position.

Enphase Energy (ENPH) – Solar has been a frustrating area for most investors. It’s a great secular growth story and the technology is consistently improving. Yet unit prices decline faster than volume can ramp. Coupled with high capital costs and shifting regulatory factors there have been few attractive ways to invest. Enphase makes inverter technology which is needed to take the DC from solar cells and panels and create AC for use. Traditionally these inverters are large, centralized and somewhat mysterious pieces of equipment. In fact knowing how to design and install a system is made difficult mostly due to the need for special engineering around the inverter. Enphase has come up with “micro-inverters” which are small enough to attach to individual panels and perform the conversion at the source. The company has proven an ability to scale revenue and profit with units. The company recently completed an IPO in a market that is still hostile to solar and unfriendly to alternative energy (Enerkem, Luca Techologies and BrightSource all got withdrawn.) The Enphase deal priced at the low end ($6) of the revised downward range (originally $10 to $12/share.) Our IV of $12 allowed us to finally include a play on solar that fits our investment profile and offers substantial upside.

Process Update

In terms of our investment process we made one change in April. Typically we use the current year estimate for IV in our decision process. However for “core” positions we decided that an extra year helps to make better decisions that are consistent with our long-term approach. By having an IV for both 2012 and 2013 we can make better decisions. We don’t try to analyze the economy or markets in general but we can say that many potential positions in April didn’t make the cut because those stocks are trading at or above our IV estimates, in many cases even the ones we have for 2013. There’s evidence of investors getting carried away in some niche areas and with a few stocks but our IV process keeps doing the job for us. We’ve been adding all these names to our database of companies organized by theme so that if opportunities develop in some of these stocks we will be prepared. We may also look for shorts in this market starting in May. There are some technology trends we see ending and there may be cases where that isn’t reflected in some of the stocks of companies positioned in those areas.

A Little Gem

Even though we will own large well-known names if the technology trends and potential returns justify it, we will do the work on very small companies that are largely unknown to investors even though they are tapping into key trends we follow. One of those names is Cinedigm (CIDM) which we have followed for over two years and owned since late 2011.

When we first saw Cinedigm they had a decent business helping theaters to convert to digital and 3D technologies. Their long-time CEO was a good guy and a don of the industry niche. The business though was a little boring and not growing much. Underneath it all though was a position in software that put the company at the heart of what would be an important transition to “all digital” for the cinema industry. But it wasn’t clear to what degree this position would be leveraged and brought to the surface.

It didn’t take long for some changes to sharpen our focus on the company. The long-time CEO resigned and the company set out to hire a new one. At the beginning of 2011 an industry heavyweight with a strong background in filmed entertainment content came on board. This was a classic case of a big vision in a small company and we saw a flurry of events in 2011 as the company shed non-core businesses and accelerated their growth and profitability.

Wall Street noticed at first and the shares moved from $1.50 to over $2.00. While everyone was in agreement that the management team was doing what the promised and demonstrating material improvements in results the company was still lacking a convincing alternative content strategy. Knowing the CEO we were sure it would happen over time so took advantage of lower share prices in Q42011.

Recently Cinedigm completed a small ($10M) equity offering and acquired a company called New Video. We see this as a huge catalyst for growth and strategic value that so far is unappreciated by most investors. New Video is responsible for a big chunk of the content in places like iTunes, Netflix and Amazon. They finally give Cinedigm the critical mass they need in content.

At the same time they have been investing heavily in their software and building the team to drive it. In many ways they have a captive market for their software which enables cinemas to program content and for content owners to track and manage rights and revenue. This software will also be a core element of what enables the company to deliver new content distribution business models where cinemas are able to participate in downstream revenues.

It’s going to take time for the Cinedigm story to unfold and it still presents challenges to investors who often won’t take the time to look through an unusual balance sheet or believe in a new business model. But we see reward that is greater than the risk here with an IV of $6 versus the current $1.50 share price. We may realize it in 2013 or 2014 but when we do it will be a substantial return for the portfolio.

Upcoming Events

We will be in NYC in May attending TechCrunch Disrupt on the 21st and 22nd which gives us an opportunity to see a great deal of the latest technology innovations in one place. We’re hoping that the trip provides enough research to support idea or two with the appreciation potential to make it into the portfolio.

LinkedIn struggled over the years to expand usage and discover business models that would generate revenue. They had some luck with using the platform for recruiting and selling premium subscriptions to LinkedIn power users. But most business users and corporations were not really thinking social.

Companies realized that recruiting on LinkedIn was very effective and especially liked going after potential employees that were not actively looking for a new job. Employees soon realized that completing their profile and polishing it with links and updates was good for career advancement.

But Facebook (FB) (and to some extent Twitter) create an awareness of social sharing that has helped professionals and organizations adopt the practice. At the same time most business users do not want to use FB for their professional activities and emerging professionals that grew up on FB are eager to embrace a new service where they can showcase their “business side.”

Fortunately for LinkedIn they face limited competition in this area. Existing recruiting companies like Monster failed to grasp this trend and most of the enterprise social networking tools (Yammer, SocialText, SalesForce Chatter, Jive) are aimed at internal rather than external professional networking.

Until and unless meaningful competition emerges we will maintain a core position in LinkedIn (LNKD – $99). The stock has enjoyed a strong move recently and trading at our current IV of $100.

We did take a look at Jive Software (JIVE – $26) trades far above any sensible IV we can come up with. The private company activity in this space is also hyperactive. As we write this we note that another innovative enterprise social, collaboration and decision making platform, Spigit, has just received another major round of financing.

It takes a long time for a GPT to play out from an investment standpoint. The timeframes are getting shorter but they are still measured in decades rather than quarters. For example we are over 40 years into the microprocessor revolution and still going strong. The internet, smart phones and networks are just applications.

Nanotechnology is emerging as a GPT that broadens the application of technology to materials, biology, analog electronics and will ultimately work into far more areas than we can imagine now. Again the microprocessor is a great analogy. What we have today in digital technology was the stuff of pure science fiction only 20-30 years ago. Nano is just getting started.

This is important investing theme for the SVTF. As exotic as some of the technology is the key remains product engineering, business models, management and execution. Fortunately the market potential for nanotechnology is gigantic given the broad applications in medicine, materials, and energy. Each of those markets can be measured in trillions of dollars. Not bad.

But physical 3D has also been getting more adoption and attention in the last year. The details might be a bit hard to see from this Google Trends graph but when in terms of “3D printing” it is definitely up and to the right.

This trend has been brewing for several years now in both consumer products and industrial manufacturing. The consumer movement with the success of O’Reilly’s “Make” magazine. It has inspired millions of people to “hack stuff” and think about things differently. The company that best captures this spirit is MakerBot Industries. MakerBot is about building open source robots. Their early efforts didn’t seem serious but after raising $10M in private capital from many of the smartest early stage investors the company started to gather momentum and have the resources to really develop their product.

For an even longer time there have been industrial applications using so-called “3D printers” from public companies like Three-D Systems (NYSE: DDD – $24.98) and Stratasys (Nasdaq: SSYS – $38.97). A few years ago these printed received some fame when Jay Leno talked about using one for custom motorcycle parts. These two companies have been around for a long time and have grown in fits and starts. Over the past decade it’s been easy to get frustrated owning these stocks depending on when you bought them.

There’s been some new blood flowing in the industrial segment with new startup companies getting funding and a spread of innovation in not only devices but materials, applications and use cases. There’s been a significant recent IPO as well: Proto Labs (NASDAQ: PRLB – $28) came public at $16 and quickly traded up to settle in just a few dollars below our IV estimate. The $650M market capitalization will certainly fuel more investment in 3D technologies.

Dassault Systems (PINK: DASTY (ADR) – $83.72) is the dominant software company in the 3D and RealVR market. Dassault is closing in on $3B in annual revenues with a 28% operating margin. We are working on finding some smaller companies to add to the portfolio but with an IV of $107 we believe DASTY is a core position.

Connected Car: The electronic content of automobiles has been on the rise for decades. Mechanical elements have been replaced by electronic and power-assisted components. Back in 1993 Cummins Engine was showing off one of their engines that had four intel processors in it. Those processors have proliferated and most cars have even had their own “local area network (LAN)” for years as well. Now cars are shifting into network-attached, processor intensive machines. They are or soon will be as connected as your iPhone. At the same time the last element of purely mechanical design, the drivetrain, is being replaces as well.

Design: It can be a frustratingly “soft” science (just ask Dell and Microsoft) but it is increasingly powerful. Consumers want inspired design and are willing to pay for it. There may be nothing as powerful for many consumers as their connection with their car. It is a visceral feeling that is attached to a high ticket purchase that requires substantial maintenance. Design has played a big role in automobiles with covered design names like Pininfarina. Conventional companies like Ferrari, Porsche, BMW and Mercedes all understand the importance of design in automobiles. Tesla is another one and they bring to it a more technology-focused approach to innovation. People love the design that Tesla brings to their cars and this is a powerful trend.

Performance EV: There are no shortage of doubters and detractors around electronic vehicles. Range anxiety is real, cost is an issue, grid readiness matters, but most of these pertain to mainstream and mid-market adoption. A Ferrari isn’t practical for most of the people that own one but that wasn’t part of their decision process. Lower ticket items like the “weekend convertible” or motorcycle fall into the same category. The truth is that electric vehicles offer much better performance and handling than conventional drivetrains. If you think about it for one moment the ability to power each wheel separately gives car designers a whole new frontier. Many investors think about an EV as a glorified golf cart. They obviously have never driven a Tesla.

Given that Tesla sits at the intersection of three important trends in emerging technology it is a perfect candidate for our portfolio. With an IV of $55 the shares offer substantial upside. We do note that much of the intrinsic value for Tesla is “back end loaded” which means it really begins to kick in after 2015. So the shares may ebb and flow with investor sentiment. Armed with our IV we will be in the market to keep positioned accordingly.

• First and foremost Zynga has a fabulous business: rapid revenue growth to reach a $1B run rate combined with 20% operating margins and $1.8B in cash. These are some of the strongest financials anywhere in the technology space.
• Zynga is dominating a huge new market. Casual gaming is a big trend and the online social element adds new levels of engagement and expands the market even further. Although personally I am not a big fan of online gaming, hundreds of millions of people are. The adoption of mobile devices and and more social gaming options continues to drive the market.
• The established gaming companies like Electronic Arts and Activision have largely missed this major shift in the market. Zynga has developed a different approach to not just building and launching games but one of seeing games as evolving interactive content platforms that demand a mindset, development process and business strategy all geared to this.
• Investors disliked the company from the start and have so far tended to focus on the negative aspects of the company rather than the positives. The founder and CEO is a controversial figure but that in itself isn’t a reason to avoid the company. The same can be said about Andrew Mason (GroupOn), Mark Zuckerberg (FaceBook) and the late Steve Jobs (Apple.) It remains to be seen how  Marc Pincus leads Zynga as a public company.

Underscoring all the fundamentals is our IV estimate of $25 for the shares which has been well below prevailing market prices since their IPO.

Zynga is a name that demands careful watching and more frequent reviews of our investment case and IV estimate. However today we are confortable owning the shares in an era of increasing mobile, social and casual gameplay.