Stock Market Basics: How to Select the Best Tech Stocks

tech stocksPicking the Best Technology Stocks as “4IR” Takes Off

Steam engine. Electricity. Internet. Do you see the common denominator here? All three are technological innovations, and all three respectively sparked the first three industrial revolutions of human civilization.

We’re now witnessing the “Fourth Industrial Revolution” (4IR), and technology has once again laid the groundwork. It’s obvious that the tech sector boasts some of the most lucrative investments of our time. So, naturally everybody is out looking for the best tech stocks. If you’re a newbie, you must check out the stock market basics of investing in the tech sector.  

Now, just imagine, if you didn’t have technology, you’d probably still be milking cows and digging wells in some small village in the middle of nowhere. With the blessing of technology, you migrated from that village to the global village. Such is the power of technology!

There’s no doubting that the tech sector is now the “alpha male” of all sectors. That’s because this is the only sector that now powers virtually every other industry, big or small. Yes, technology has encroached upon retail, healthcare, automotive, utilities, industrials—you name it!

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Why Invest in Technology Companies

My dear friends, this is the Fourth Industrial Revolution, or as some of us like to call it, the “4IR.” All of the next-generation technologies you keep hearing about, like artificial intelligence, the Internet of Things (IoT), autonomous vehicles, implantable nano chips, so on and so forth, are actually the gifts of the 4IR—and together, they are revolutionizing all of our business sectors, not just tech.

But if all that sounds to you like the ramblings of an imaginative fangirl, how about I show you the facts?

The chart below shows what the performance of the tech sector looks like against the S&P 500 Index for just one year. No, I didn’t cherry pick the good part. You can go back five years, 10 years, 20 years, or beyond, and it’s clear that the tech sector has historically outperformed the market.

IYW stock chart

Chart courtesy of StockCharts.com

The reality is that technology companies are witnessing hypergrowth, and that growth is translating into their stock prices. Suffice it to say, the best tech stocks are now the top dogs of the investing world. 

How to Invest in Tech Stocks?

The question that boggles the minds of most value investors  is: “how do I invest in tech stocks?” There are some stark reasons for it. Stay with me as I go on to reveal my two tips for finding the best tech stocks.

For starters, fundamentals fail us in the tech sector. So, all those typical valuation methods we learn in Finance 101 are no more than fluff when valuing tech stocks. Think about it: what’s the go-to valuation metric for an average company? Price multiples, right? But, guess what. Tech companies have some of the most inflated price multiples.

Just take a look at Amazon.com, Inc. (NASDAQ:AMZN) stock that’s trading at 185 times its earnings. If you were to pick a tech stock just by looking at its price-to-earnings (P/E) or price-to-sales (P/S) or price-to-book (P/B) ratios, you’d sidestep the stock without giving it a second look.

Even though the company in question here is the biggest e-tailer and one of the fastest growing companies in the world, which delivered 2000% in returns to AMZN stockholders every 10 years! For me, this is one of the best tech stocks, but price multiples suggest otherwise.

Secondly, the tech sector is “always in beta,” which means it is constantly evolving. This is why no single company maintains a lead in perpetuum. Look at Yahoo! Inc. (NASDAQ:YHOO) or BlackBerry Ltd (NASDAQ:BBRY), which got burnt to the ground. On the contrary, look at Apple Inc. (NASDAQ:AAPL), which sprang back up from the dead. In short, it is not like retail, healthcare, or automotive, where the long-established names lead the pecking order forever.  

And finally, because the evolution is so hypersonic, technology companies have to keep reinvesting their earnings into research and development (R&D) to stay ahead of the curve. One formula cannot last them a lifetime like it does for, say, The Coca-Cola Co (NYSE:KO).

To understand this better, take the famous Moore’s law, which is nearly the equivalent of Charles Darwin’s Theory of Evolution for the tech sector. The Moore’s law says that the processing power of computing chips doubles every year! Just imagine keeping up with that evolutionary pace!

The “law”, formulated by Intel Corporation (NASDAQ:INTC) founder Gordon Moore, is what pushed the evolution of a mobile phone from merely a calling device to an all-encompassing hi-tech smart gadget, within barely a decade.

Long story short: tech companies have to flex extra muscles to stay relevant. And now that you know the stock market basics, let’s get down to business.

How to Select Best Tech Stocks?

Cutting straight to the point, it’s obvious that we can’t pick the best tech stocks with traditional valuation models. So, here’s how I shortlist them.

There are roughly two kinds of technology companies: profitable and unprofitable. Do not, I repeat, do not disregard a tech company for merely its unprofitability—not even penny stocks! Many unprofitable tech companies are in their nascent phase. Rest assured that if a company has a promising product or service, money will eventually flow into it.

So, to begin, here’s how I value profitable tech companies.

Let’s suppose you’re considering a tech company X with a market capitalization of $760.0 billion, which is roughly generating $45.0 billion in annual earnings. Now make a wild supposition that you have all the money in the world to buy all of this company’s outstanding shares. The annual return on your investment would turn out to be 5.9% ($45.00/$760.00).

Next, find your opportunity cost. If you hadn’t invested in the company, where would you have safely put your money? Treasury bonds? They are yielding 2.4%, as of late.

Now ask yourself; would you settle for only 2.4% when you can make more than double of that return in the tech stock? I would pick the tech stock here, which, by the way, is no hypothetical company. It is Apple! And my calculation tells me that it is, hands down, one of the best tech stocks out there.

For profitable tech companies, this is one quick way of finding undervalued tech stocks. It lets you compare your prospective return with the next best alternative of Treasury bonds. In short, you get an idea of what you’d be losing or, for that matter, gaining.

But what if the tech company is not profitable (and you’d find many like that!)?

This second method hinges on your judgment, but judgments must find basis on facts. Like Peter Lynch says, “Behind every stock is a company. Find out what it’s doing.”

I like to check on three things.

  1. The company’s “cash cow” (the company’s primary source of revenue);
  2. The company’s place in the industry; and
  3. The future of the industry.

Now, there are a ton of industries within the tech sector—semiconductors, IT, biotech, hardware, software, Internet, and now even automotives, to name a few. So whichever is picked, I like to project where it’ll be heading in the next five years. That’s exactly where its stock will be heading, too.

Take, for instance, Tesla Inc (NASDAQ:TSLA). Its primary cash cow is its hi-tech, semi-autonomous electric vehicles (EVs). Tesla is currently the only company of its kind out there so naturally it dominates this niche. Finally, as more and more countries around the world are pledging their allegiance to a sustainable green future, the future of EVs seems nothing but rosy. In short; TSLA stock has everything going in its favor. 

This is just one example. Any tech company can, likewise, be analyzed on the same lines. The best part is that this method doesn’t require any number crunching.

Final Take on Investing in Best Tech Stocks

Tech was once the boogeyman that scared value investors. But this boogeyman is now out of the closet and even the most traditional of value investors like Warren Buffett are no longer shying away from it.

Amazon, Apple, and Tesla stocks may be three of the best tech stocks of our time. But the list doesn’t exhaust on these names. Indeed, there are a bunch of other promising tech investments out there. If you grasped the stock market basics, then hopefully my two selection methods will help you in filtering out your top tech stock picks.

My bottom line is that it is no longer a prophecy that the best tech stocks will be the biggest beneficiaries of the 4IR. That’s because it’s evident that technology companies are now at the core of this revolution. Ask yourself; Wouldn’t you want to be part of the “tech rush?”