Market mood swings are one thing to consider but the smart investor knows how to pick the technology stock that will endure. Tips on making money.
First of all, it is important to recognize that technology trades on the future to a much higher degree than other sectors. This extra emphasis on future upside skews many common evaluation methods (hence the frequently sky-high P/E ratios.)
There are only so many ways you can package and sell toothpaste; a strong toothpaste manufacturer with good cash flow and little debt will likely do ok in the years to come. Crunch the numbers and you'll most likely get a fairly accurate picture of what's ahead. On the other hand, the odds of an out-of-the-park homerun that triples your money within a year are pretty slim.
Enter tech stocks. If you snap up a good software maker with little current assets but terrific future prospects, you stand to bag a substantial pile of moolah. Can you say 'Microsoft: the early years'? Unfortunately, if things don't pan out things turn sour in a hurry, since there are notoriously little substantial assets in software companies.
Software makers in particular are sensitive since a good part of the company is its employees; if enough of the key players leave, there's nobody to carry the torch. Granted, a big player probably has a few successful products lines, but without innovation the competitors will soon swoop in and make the products obsolete. This brings us to the next point: the time factor.
A tool manufacturer who doesn't sell its products suffers from lack of revenue and has to carry the cost of a bloated inventory. However, a stored hammer remains a perfectly sellable hammer, even if it sits in a warehouse for a year. If you're a tech hardware company, you also have the issue of obsolescence to content with.
Who would buy a 2-year old server that has been sitting in a warehouse, when you can get a brand new server elsewhere with more bells and whistles for half the price?
All these problems are compounded by the mystique that surrounds tech stocks. When the pendulum swings to "hot," everybody throws money at even obvious losers. 40 lb bags of pet food shipped by UPS from across the country, anyone? Bubbles are easily formed, and when there's a bubble, there's often a pop to go with it. Then yesterday's darling becomes something the cat dragged in.
So what does all this mean? Should you forgo potential home runs for safety? Or should you just hold your nose, dive in and hope you timed it just right? To answer this, there are a few key questions to ask yourself beforehand that will do a lot to take the uncertainty out of the equation:
1. Do I know this business? It's the Peter Lynch approach - if you have no idea what company X does, what on earth are you doing buying its stock? Since tech stocks in particular trade on future expectations, you must have a clear grasp of what the company does and how it plans on reaching its goals. Don't rely on buzzwords - a "systems management optimization suite for streamlining vertical applications" can be anything. Ask instead: "What is the exact functionality that the customer finds it worth paying for?"
2. How much are you willing to pay for the potential upside? Tech stocks historically trade at a premium to take the potential growth. A P/E ratio of 40 is rich, but perfectly reasonable for a company with proven good products and sensible managers. A P/E ratio of 200+ is not.
3. What's in the rest of my portfolio? If you're planning to plunk down 80% of your net worth in a growing tech company, better keep that Pepto Bismol handy - either you'll be on your way to a mansion or the poorhouse. As a minor component of a balanced portfolio with some bonds, REITs and blue chips, on the other hand, you'll at least stay in your current, humble abode.
