Picking the Best Technology Stocks as “4IR” Takes Off
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. 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.
There’s no doubt that the tech sector 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 encroached upon retail, healthcare, automotive, utilities, industrials—you name it!
Just imagine, if you didn’t have advanced technology, you’d probably still be milking cows and digging wells in some small village in the middle of nowhere. With the power of technology, you have migrated from that village to the global village.
2019 is going to be an exciting year for tech stocks as companies look for ways to use technology to become more innovative, efficient, agile, and competitive.
Why Invest in Technology Companies?
My dear friends, we are in the Fourth Industrial Revolution, or as some of us like to call it, “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 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 performed against the S&P 500 over a two-year period. We didn’t cherry pick the good parts. That’s clear because we included 2018, which was a very volatile year for stocks. In fact, 2018 was the worst year for stocks in a decade, and it was 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 2019.
How to Invest in Tech Stocks in 2019
The question that vexes most value investors is: “How do I invest in the best tech stocks in 2019?” There’s more to it than just picking the top trending tech stocks.
There are two key factors you need to pay attention to in order to uncover the best tech stocks.
First, fundamentals fail us in the tech sector; all those typical valuation methods we learned 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 look at Amazon.com, Inc. (NASDAQ:AMZN), a stock that’s trading at 59 times its earnings. 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 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—in the world, delivering 2,000% in returns to stockholders every 10 years! For 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 a lead in perpetuity.
Look at the former Yahoo! Inc. (NASDAQ:YHOO) and BlackBerry Ltd. (NASDAQ:BBRY), both of which got burnt to the ground (financially speaking). In contrast, 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 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, The Coca-Cola Co. (NYSE:KO).
To understand this better, take the famous Moore’s law, which is nearly the tech-sector equivalent of Charles Darwin’s Theory of Evolution. Moore’s law says that the processing power of computing 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 a 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 to stay relevant.
How to Select the Best Tech Stocks
Now that you know the stock market basics, let’s cut straight to the chase. It’s obvious that we 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 that 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 $740.0 billion and generates roughly $55.0 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 be 7.4% ($55.00/$740.00).
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 are yielding less than 2.5% as of late.
Now ask yourself, would you settle for only 2.5% when you can make three times that return from a tech stock? I would pick the tech stock, which, by the way, is no hypothetical company; it’s 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. 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 (and you’ll find many like that)?
This second method hinges on your judgment, but 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 on three things:
- The company’s “cash cow” (its primary source of revenue)
- The company’s place in the industry
- The future of the industry
Also Read: Top Tech Trends for 2019
Now, there are a ton of industries within the tech sector—semiconductors, IT, biotech, hardware, software, Internet, and automotive—to name a few. Whichever industry I pick, I like to project where it will be heading in the next five years. That’s exactly where its stock will be heading, too.
Take, for instance, Etsy, Inc. (NASDAQ:ETSY), the e-commerce marketplace for unique, one-of-a-kind products. Think of it as the antithesis of Amazon. Its primary cash cow is its gross merchandising sales (GMS), which have been soaring. In 2017, Etsy’s GMS was up 14.5% year-over-year—at almost $3.3 billion. For 2018, GMS is forecast to have advanced approximately 20% to $3.9 billion.
Etsy, a leader in a niche industry, is investing for future growth. That includes increasing its spending on marketing and product initiatives, as well as on migrating to the cloud.
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 very much 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 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 the stock market basics, then hopefully the two selection methods described above will help you narrow down your top tech stock picks.
The bottom line is that it’s no longer just a prophecy that the best tech stocks will be the biggest beneficiaries of 4IR. It’s already evident that technology companies are at the core of this revolution. And who wouldn’t want to be part of this “tech rush?”