Don’t Judge a Book Solely by its Cover

By: Jared LevyApril 13, 2012

In all probability, at least one of your parents offered this idiom during your formative years. What’s most interesting about the metaphor is that most of us still don’t always listen. When you think about it, the reason most of us buy many of the products we do (including stocks) is based upon their exterior. More accurately, we may get past the cover but seldom read the whole book.

Rarely do we truly dig deep beneath the surface more than a page or two. With products, we may read some reviews online, ask a friend and maybe examine the product for true quality before purchasing. With investments, we usually check a couple of key fundamental metrics and maybe look at a chart to identify trends, support, resistance, etc. and then click the “buy” button. If you follow us here at Zacks, you may buy a stock solely on its Zacks Rank.

There is nothing wrong with this investing approach if you are finding success; but can more value be unlocked if we look deeper?

The Derivative Trades
Derivative trades are investments that lie beneath the surface. They are opportunities that derive value from the success of a product and might just give you more returns than the original stock itself. The analogy would be if you found that accountants who went to Harvard were getting the best and quickest refunds for their clients at tax time. Sure you could hire one of those Harvard accounts to do your taxes; but what if you looked deeper and found they all were using a particular type of software? Maybe the better investment would be the software itself.

Because of its immense popularity, I’ll use Apple as an example. The iPhone as a product is sleek, well constructed and functions as it’s supposed to (I just bought the 4S). The millions that have been sold are a testament to its exterior quality and the genius of its manufacturer.

But what about its construction? What of the chips, radios and even metals used to construct those components and even the carriers that allow it to function?

I can’t tell you that I am the first to talk about derivative trades; but hopefully I can offer some unique insight and maybe help your thought process when it comes to derivative trades.

Deconstructing the Smartphone
Finding the most effective derivative trades shouldn’t be limited to one product. Find a common thread woven through multiple products in a sector; that way you can build a stronger thesis for your trade.

For the smartphone it’s not just about Apple, Google’s Android (Motorola), HTC, Microsoft, Nokia, Samsung, Blackberry, LG, Kyocera and more are all producing phones to gain customer popularity. If we were to disassemble all the phones, what would we find that could be potential investments?

More to the Touch Screen
Gorilla Glass, which is produced and sold by Corning (GLW), is the popular choice for touch screen mobile devices of all sizes and shapes.

Beneath the protective gorilla glass (which is coated in a conductive material so you can interact with it) is a touch screen controller that senses where your fingers are swiping, it might be made by Atmel (ATML) or Texas Instruments (TXN).

One layer down is the display itself, which is the heart and soul of the phone. Displays are manufactured by LG, Samsung, Densitron (which trades in London) among many others. If your phone uses OLED technology, Universal Display Co. (PANL) may be getting a royalty. Universal Display Corp. is the brains (and holds many patents) behind a good part of OLED technology. I was the first to talk about PANL on CNBC back in 2009.

Crunching Data
Qualcomm Inc (QCOM) produces many of the power management and cellular connectivity processors that go into many smartphones. You may recognize the brand name “Snapdragon.” What you may not have known is that the patents for some of those processors come from a company called ARM Holdings (ARMH), whose technology is in roughly 93% of all Smartphones; you can learn more here.

Motorola Mobility (now owned by Google GOOG) provides main processors for many Smartphones (iPhone uses their own). Texas Instruments provides hardware support for Wi-Fi, Bluetooth, FM radio and GPS functionality. Skyworks (SWKS) inserts their cellular power hardware into many smartphones and wireless devices. They also manufacture the full wireless chipsets for phones.

Samsung is a popular supplier of much of the memory needs of smartphones, but there are other players in the game.

The bottom line is that you may be able to find value in the maker of a great product like the iPhone or Android, but if you look inside and find the companies that are exposed to all of them, you may have an even bigger opportunity to profit. Even rare earth investments are being made in relation to the popularity and growth expectations for mobile devices.