Stock Market Basics: How to Select the Best Tech Stocks in 2020

Stock Market Basics: How to Select the Best Tech Stocks in 2020Picking the Best Tech Stocks as “4IR” Takes Off

The steam engine, electricity, the Internet. Do you see the common denominator? All three are technological innovations, and all three respectively sparked the first three industrial revolutions.

We’re now witnessing the “Fourth Industrial Revolution” (4IR), and technology has once again laid the groundwork. The tech sector boasts some of the most lucrative investments of our time. So naturally, everybody is out looking for the best tech stocks.

There’s no doubt that tech is the “alpha dog” of all sectors. That’s because this is the only sector that powers virtually every other industry, big or small. Yes, new technologies have popped up in retail, healthcare, automotive, utilities, industrials—you name it!

The year 2020 is going to be another exciting year for tech stocks as companies look for ways to use technology to become more innovative, efficient, agile, and competitive.

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Why Invest in Technology Companies?

My dear friends, as I just mentioned, we are in the era of the 4IR. All the next-generation technologies you keep hearing about, like cloud computing, the Internet of Things (IoT), artificial intelligence (AI), autonomous vehicles, implantable nanochips, and so forth are gifts of the 4IR.

Together, they are revolutionizing almost all business sectors, not just the tech sector. All the proof you need is in the following chart:

Chart courtesy of StockCharts.com

The above chart shows how the tech sector, as represented by the iShares Dow Jones US Technology ETF (NYSEARCA:IYW) (in green), performed against the S&P 500 index (in purple) over a three-year period.

I didn’t cherry pick the good parts. That’s clear because I included 2018, which was a very volatile year for stocks. In fact, 2018 was the worst year for stocks in a decade, and it included the worst December on Wall Street since the Great Depression!

Despite the doom and gloom in 2018, tech stocks still outperformed the broader market—something they have done consistently. You can go back five, 10, or 20 years (or beyond) and it’s clear that the tech sector has been the historical winner.

The reality is that technology companies are witnessing hypergrowth, and that growth is translating into higher tech stock prices. Suffice it to say, the best tech stocks are now the top dogs of the investing world in 2020.

How to Invest in Tech Stocks in 2020

One question that vexes many value investors is: “How do I invest in the best tech stocks in 2020?”

There’s more to it than just picking the top trending stocks.

There are two key factors you need to pay attention to in order to uncover the best stocks in the tech sector.

First, fundamentals fail us when it comes to the tech industry; all the typical valuation methods we learned in Finance 101 are no more than fluff when valuing these 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 look at Amazon.com, Inc. (NASDAQ:AMZN), a stock that’s trading at 70 times its earnings (as of this writing). If you were to pick a tech stock just by looking at its price-to-earnings (P/E), price-to-sales (P/S), or price-to-book (P/B) ratios, you’d likely sidestep AMZN stock without giving it a second look.

That’s even though Amazon is the biggest e-commerce business—and one of the fastest-growing companies of any sector—in the world, delivering about 2,000% in returns to stockholders every 10 years! To me, this is one of the best tech stocks, but its price multiples would suggest otherwise.

Second, the tech sector is always in “beta,” which means it is constantly evolving. That’s why no single technology company maintains its lead in perpetuity.

Look at Yahoo! and BlackBerry Ltd. (NYSE:BB), both of which got burnt to the ground (financially speaking, although BlackBerry has been rising from the ashes). In contrast, look at Apple Inc. (NASDAQ:AAPL), which sprang back from the dead.

In short, tech is not like retail, healthcare, or automotive, where the long-established names lead the pack almost forever.

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

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

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

Long story short: tech companies have to flex extra muscles in order to stay relevant.

How to Select the Best Tech Stocks

Now that you know the stock-market basics, let’s cut to the chase. It’s obvious that you can’t pick the best tech stocks by using 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 simply because it isn’t profitable at the moment—not even tech penny stocks! Many unprofitable tech companies are in their nascent phase.

Rest assured, if a company has a promising product or service, money will eventually flow into it.

Here’s how I value profitable tech companies.

Let’s suppose you’re considering tech company X, which has a market capitalization of $1.3 trillion and generates roughly $55.0 billion in annual earnings.

Now, make a wild supposition that you have the money to buy all of this company’s outstanding shares. The annual return on your investment would be four percent (55 ÷ 1,300).

Next, find your opportunity cost. If you hadn’t invested in the company, where would you have put your money? Five-year Treasury bonds? They have been yielding less than 1.6% as of late.

Would you settle for only 1.6% when you can make more than twice that from a tech stock?

By the way, this is no hypothetical company: it’s Apple! And by my calculations, 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. That way you get an idea of what you’d be losing or, for that matter, gaining.

But what if the tech company is not profitable yet?

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

I like to check three things:

  • The company’s primary source of revenue
  • The company’s position in its industry
  • The future of the industry

Also Read: Tech Stock Analysis: Top Tech Trends of 2020; Part 1 and Tech Stock Analysis: Top Tech Trends of 2020; Part 2

Now, there are a ton of subsectors within the tech sector: semiconductors, IT, biotech, hardware, software, Internet, and automotive, to name a few. Whichever industry I look at, I like to project where it will be heading in the next five years. That’s likely where its stock will be heading, too.

Take, for instance, Etsy Inc (NASDAQ:ETSY), which runs an e-commerce marketplace for unique, one-of-a-kind products. Think of it as the antithesis of Amazon. Its primary source of revenue is its gross merchandising sales (GMS), which have been soaring.

In 2017, Etsy’s GMS went up 14.5% year-over-year to almost $3.3 billion. In 2018, it went up 20.8% to $3.9 billion. And in 2019, the company’s GMS was projected to climb 25%.

Etsy, a leader in a niche industry, is investing for future growth. That includes increasing its spending on marketing, product initiatives, acquisitions, and migrating to the cloud.

Any tech company can, likewise, be analyzed along the same lines. The best part is that this method doesn’t require very much number-crunching.

Analyst Take

Tech was once the boogeyman that scared many value investors, but this boogeyman is now out of the shadows. Even the most traditional value investors, like the once-tech-shy Warren Buffett, are on board.

Amazon, Apple, and the overlooked Etsy may be three of the best tech stocks out there right now. But this tiny list is hardly exhaustive. Indeed, there are several other promising tech investments out there.

If you grasp stock-market basics, then hopefully the two selection methods described above will help you narrow down the current top stocks in the tech sector.

The bottom line is that it’s no longer just a prophecy that tech stocks will be the biggest beneficiaries of 4IR. It’s already evident that technology companies are at the core of this new industrial revolution.