The Motley Fool: How to make great chips

Since the conception of the Motley Fool's Rule Shaker portfolio, one of the most popular companies on the Fool message boards, and the one most frequently suggested as a potential Rule Breaker, is ARM Holdings.

A Rule Breaker, don't forget, is a company that refuses to live by the rules of its predecessors. Instead, it scraps them and makes its own rules.

So what does ARM do? To put it very simply, it designs chips. Computer chips, that is. ARM's specific expertise is in the area of processor chips aimed at portable computing and communications devices (which mostly means palm-top computers and mobile phones).

ARM's chip designs are also at the core of the Symbian alliance, which is attempting to forge the next standard in portable computers through its EPOC platform. This alliance puts the company in partnership with Psion, the early pioneer of pocket-sized computers.

The Symbian alliance also includes such development partners as Motorola, Sun Microsystems and Intel.

A Rule Breaker should be the top dog and first mover in an important and emerging industry. ARM certainly has the lion's share of its market so far. Whether it was technically the first to create such chip designs is open to debate, but nobody else has captured the first mover advantage in the same way.

ARM designs appear in all sorts of other computing devices, but mobile communications and computing constitute the major part of the company's market. The tricky part of analysing this market is attempting to predict how well the Symbian side of it will fare. If Symbian is a success (which, with the likes of Microsoft against it, isn't certain), ARM will profit hugely. If it fails, however, ARM's share price is likely to take quite a hit.

The next thing we want to see is sustainable advantage. ARM has built up a pretty good momentum in chip design sales, and with companies like Intel fabricating them, the economies of scale available make the costs pretty reasonable.

It would be hard to break into this market significantly, though not impossible, for companies like Motorola. Copyrights on the company's designs, and the vision that has helped it stamp its name on its market, also help to win this one for ARM.

We also look for strong price appreciation, with the company's share price beating at least 90 per cent of the market. ARM's price has beaten a whopping 98 per cent.

Here we must sound a note of caution, however. A fair proportion of that price appreciation has to be based on the expected success of the Symbian alliance. Just watch the top movers on Teletext each day; whenever Psion is in there, ARM is usually there too.

If the "top dog" criterion is satisfied by ARM's dominance of its market, but a lot of its share price appreciation is on the back of the as-yet unproven Symbian technology, we need to think carefully.

Does ARM have smart backing and good management? That's the next criterion, and it seems like a pretty easy one. Look at the companies doing business with ARM, both in current markets and in the Symbian alliance. Management that got its foot in those doors has to be doing something right, don't you think? Strong customer appeal is also needed, and so many manufacturers are using the fact that they are ARM based to sell their products, that ARM has to score on this one.

Finally, we want to see people claiming that the company is overvalued. With a forward p/e ratio of around 300, there's no shortage of such claims.

So will ARM make it into our portfolio? The uncertainties raised by the Symbian alliance are making us take considerable care, but ARM has made it on to our shortlist.

As always, don't forget that this Foolish analysis is not a recommendation of any sort. For your own investments, you must make up your own minds. Foolish investors never blindly follow the opinions of others.

More discussion at the Fool website: www.fool.co.uk

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