Technology Stock Investing - Keys To Success

Includes: AAPL, IBM, MSFT
by: Silicon Valley Insights

1. Product cycles trump most business cycles

2. Innovation versus competition

3. Judge managements as businesspeople

4. Look for large markets

5. Be a momentum investor

6. Retain winners, quickly sell losers

7. Buy highly profitable cash generators

8. Many major trends are not hard to see -- like tablets replacing PCs

Investing in the best technology stocks can be very financially rewarding. We encourage you to use these keys to successful investing in tech stocks and see if you enjoy the process and make money.

1. Product cycles trump most business cycles

Product cycles are the time from when new products are anticipated, then announced, then shipped, to the time when the next successive product is anticipated, announced and shipped.

If a new product is an exciting advance, demand can exceed supply and prices will be strong. When a product is in the later stages of its product cycle and soon to be replaced, demand and the prices buyers will pay often soften.

The impact of product cycles on company profits has been clear since the 1960s. For example, since the 1960s and 1970s, IBM's (NYSE:IBM) stock earnings growth and stock price have been driven by its most important product cycles. For many years, its mainframe product cycle was key.

As each new mainframe generation was launched, earnings accelerated and so did IBM's stock price. A year or two into the product cycle, earnings growth slowed and the stock plateaued or even corrected. Mainframe product cycles were and still are about three years long.

Over the subsequent 30+ years, the same phenomenon has played out many times in the technology industry.

It can also be seen in the shares of Apple (NASDAQ:AAPL), one of the most innovative technology companies of the past decade. The difference is that Apple's product cycles last only one year or less with new models of its key iPhones and iPads launched at about the same time each year.

In all but the worst of times, technology company product cycles are the greater determinant of share prices than macroeconomic issues. This is the most true for companies that are highly innovative and make products that consumers crave.

Or if they sell to enterprises, companies with products that represent substantial advancements in performance, capability, and/or cost relative to performance, which is called "price-performance."

Companies selling to enterprises are called enterprise IT companies.

Product cycle impact on stock prices is also true for software and services companies that sell for up-front fees, usually called license fees.

It is less true for enterprise IT or consumer products companies providing their products or services on a long-term subscription basis. Or for a monthly, quarterly or annual basis for services provided over the cloud or the Internet. For these companies, it is important to look at their total billings, orders and/or backlog since customers are signing up for multi-quarter or multi-year commitments.

The big exception to product cycles ruling stock prices is during periods of extreme macroeconomic volatility. Like from early 2000 to late 2003 and from mid-2008 to early 2009.

That way, you avoid losses and having to achieve big gains in a rebounding stock market just to get back to even.

2. Innovation versus competition

In the technology sector, true innovation is highly critical and not as common as you might expect. Once a true innovator like Apple or Google (NASDAQ:GOOG) creates a product or service based on genuine new technology, other companies try to copy it.

How easy that is to do varies a lot, and it is important to correctly judge that when selecting which technology stocks to buy. Software can be copied a lot easier than a highly complex semiconductor. As a result, Microsoft (NASDAQ:MSFT) has a much bigger piracy issue in countries like China than Intel (NASDAQ:INTC) does. This results in sales of its Windows operating system software often growing more slowly than sales of PCs that run on it. Especially in times when the strongest growth is in countries where piracy is the most rampant.

In the 2000s, Apple was THE most impressive innovator, and company earnings and the stock price benefited greatly as a result. Like it did with PCs in the 1980s, in the 2000s it created entire new large markets with its iPods, iPhones and iPads. And importantly, these are very large markets. And it has patented many of its innovations and is now suing competitors that copy its products and how they operate. In mid-August 2012, it won a major victory over Samsung (OTC:SSNLF) for copying the look and feel of its iPhone. It is now going after other smartphone competitors that infringe on its patented technology.

Today, technology is so complex that often multiple companies with complimentary products are partnering with each other to create optimal complete solutions. This is especially true in the enterprise IT sector, and is s positive, it keeps them from duplicating each other's efforts, with the resulting benefit being higher profits.

Be on the lookout for increasing competition. When innovators create a hot new technology that takes off, competitors will emerge. How large and strong they are and how closely they emulate the products of the innovator is highly important to assess. Today, Samsung has taken the smartphone lead from Apple. And it wants to do the same in tablets where Apple's hit iPad is still the leader.

You don't have to be a technology expert to judge this. You just have to pay attention to new competitive offerings and watch to see if they impact the sales and growth of the innovators. Of course, the innovators will continue to move forward and often add new complimentary products to create portfolios of offerings their imitators cannot match.

Today, in the cloud computing and virtualization sectors of enterprise IT, (NYSE:CRM), Netsuite (NYSE:N) and Workday (NYSE:WDAY) are leading innovators who are expanding their range of offerings. More mature tech companies like Oracle (NASDAQ:ORCL), Microsoft and SAP (NYSE:SAP) are launching cloud versions of their products but it is hard for them to match the pace of the innovators. And their offerings sold on a license basis are slowing so much that overall revenues are flattish.

Recall, cloud computing means software is replaced with a service over the Internet cloud that is often priced on a monthly or annual basis instead of a one-time, up-front price.

Often, new innovators in hot new sectors are afforded high valuations that are warranted by their high revenue growth rates if they appear likely to continue well into the future. Many investors make the mistake of missing substantial stock price appreciation over multiple years because they are concerned about the high valuations. The key is to pay this high valuations only for stocks of the best companies with strong managements and big open new markets where they lead.

High valuations are also warranted where the most exceptional managements have demonstrated the ability to repeatedly create new products and even new markets that will add to shareholder value in the future but cannot be seen today.

If there are concerns or signs that their growth might slow, the first impact on them can be for their valuations relative to revenues to stall and then decline. If their growth rates actually do slow by more than just that related to their increasing size (the law of large numbers), their stock prices can correct substantially. Watching for slowing growth is important so that you do not lose your gains to a stock price decline.

Innovation results in rapid change in the technology sector. It means you need to spend the time to keep up, but it also creates excitement that can make investing in technology stocks enjoyable, even fun, as well as financially rewarding. Identifying a hot new technology, product or service and making money on investing in it can be exciting as well as profitable. Hopefully, this appeals to you.

3. Judge company managements as business people

Innovative new technology companies are often founded by people with technical skills and creative genius. However, many of them are quite young and inexperienced in running businesses. Often, the venture investors in new technology companies bring business experience that can be highly valuable.

Hiring experienced CEOs or COOs to run the business operations is often done once the products are launched and the companies begin to grow. Once public, investor as well as internal, customer and supplier demands must be handled. This makes a strong, well-regarded CFO very important as well.

Before investing in technology companies of any size or maturity, I highly recommend listening to the available online replays of quarterly earnings calls and other investor presentations. I suggest taking notes and keeping them if you invest in the companies you choose to investigate more closely. It can also be valuable to review the calls of key competitors.

By doing several of these calls in chronological order, you will be able to see how both the story and the financials progress. Avoid investing in stocks of companies where the managements are always talking about future potential that is not being realized when or as greatly as they previously forecast.

Doing these calls and reading company website descriptions of their products, business and news releases is important to do. And then if you invest, keep up with news by using one of the free services that send emails in real time when there is news from companies, competitors and partners in their sectors.

Again, this can be interesting and enjoyable, as well as financially rewarding if you are successful.

4. Look for large markets

When investing in growth companies like technology stocks, look for companies offering products and/or services for large or potentially large markets. Think in terms of companies addressing markets measured in billions or many billions of dollars.

Ideally, the company's offerings should be something most all consumers or and/or businesses would like to have. I often call this selling something every man, woman and child wants to own.

Or something that most all companies would find valuable in generating incremental revenues, dealing more effectively with customers and partners and/or saving money.

What you don't want to do is invest in stocks of companies that make something only a rare few scientists or other small community of customers would ever need or care to own.

5. Be a momentum investor

In the world of technology stocks, the most money is made in stocks of companies with hot new products, accelerating sales and earnings or stories that are becoming more exciting. This is a corollary to playing product cycles.

Ideally, you want to invest in technology stocks at the first sign of exciting new products -- that they are coming or were just announced. Especially if they represent exciting advances or new capabilities. Sometimes, the highest potential new products are things the investors and customers did not know could be created or that they would desire when available. Think of the Apple iPod, iPhone and iPad. Or Google searching or YouTube videos.

Often, high momentum stocks carry higher valuations, which is warranted if growth rates are high and sales and earnings appear likely to be substantially greater in coming quarters and years.

Market capitalization in dollars is the stock price per share multiplied by the number of shares outstanding. If a stock's price is $100 per share and there are 10 million shares outstanding, the valuation or market capitalization (or market cap) would be $10 billion.

Another important metric is the price-earnings ratio or P/E. It is the price per share divided by the earnings - usually for the next 12 months. When a growth company's P/E is less than the earnings growth rate it may well be attractively valued. The P/E relative to the growth rate is called the PEG ratio.

The appropriate P/E or PEG ratio varies with the quality, track record and growth outlook of the company in which you are investing. PEG ratios of up to 1:1 are considered quite modest, with ratios up to 2:1 warranted by the most exciting, fast growing innovative companies. Consider all of my Keys to Technology Stock Investing in determining an appropriate P/E.

With especially exciting new companies in high-potential new markets, companies will often "invest" in future growth by plowing most all profits back into the business so that earnings do not grow along with sales. In these cases, revenue growth needs to be high -- at least 20% per year. And more desirably 30%, 40% 50% or more. Sometimes, new companies in hot new areas even invest so much to expand that they report negative earnings. In these cases, the revenue growth should be at least 30% and preferably 50%+.

I call this being in the Investment mode.

Low profit growth during early high-revenue growth years is especially OK (even desirable) if you can see that a company's core or domestic business is profitable and only "investing" to expand overseas or develop new products or markets is keeping profits from growing along with sales.

Limit ownership of stocks of companies being in the investment mode to high quality companies with very exciting new products. And mostly limit it to newer companies. When a company transitions from the investment mode to the reaping mode, often stocks will perform (increase in price) even better.

When a company is in the reaping mode, margins and earnings will grow faster than sales. This often happens when the prior investment in new products or new markets pays off because these new offerings have come to market and sales accelerate faster than costs so margins expand. This is called positive "earnings leverage".

There are people who like investing in technology stocks on a value rather than momentum basis. But the 40-50 year history of the technology industry has shown this works much better for stocks of companies in other industries and is not as profitable as momentum investing. Except in the worst of market or economic times.

6. Retain winners, quickly sell losers

It is human nature to want to get back to even before you sell a stock that goes down after you purchase it. Experience has shown it is best to sell sooner rather than later if a stock starts to underperform other stocks in its sector and/or the overall stock market by 5-8%.

Conversely, when you have profits in stocks of great companies that continue to do well, hang on to them. Even if they correct with the market or their sector on any given day or few days.

Be especially unwilling to sell if they have even one day of a fairly sharp correction if it's just because some analyst lowered his or her recommendation because of price and valuation. When that occurs, often the stock will be weak all of that one day and rebound the next day or as soon as there is the next piece of good news.

Buying shares late in the day of a valuation downgrade is often rewarding. If adding to a full position opportunistically on that one day of weakness is quickly rewarded with a nice profit, it is fine to sell part of your over-weighted position to take it back to a full but not over-weighting.

Of course, if one stock becomes too large a percentage of your portfolio through appreciation, gradually reducing the size of your holding makes sense from a risk diversification standpoint.

7. Invest in highly profitable cash generators

A key element to successfully using the investing style I recommend here is to focus on owning high quality, highly profitable strong cash generators.

This applies to seasoned companies, not new companies, as discussed in the next section.

Companies with the most innovative products or unmatched services can charge high enough prices to have high margins and excellent profits and generate strong cash flow from their operations.

This does vary by industry sector. Leading Internet and software companies often have operating margins of 20-30%+. Companies selling components often have operating margins closer to 10% and companies selling hardware or hardware and software combinations often have operating margins in the 15-20% area.

In addition to strong margins, companies with strong cash flow per share are often the ones with the most innovative products and services.

Look for companies that have consistently replaced their own leading products with new ones that are even better before competitors do. These will often be the companies that perform well over many quarters and years so that retaining, not selling positions is the best strategy.

Of course, it is important to always be watching for any signs that their competitive lead and high margins and growth are lessening. Apple over the early part of 2013 is a good example of that.

8. Many major trends are not hard to see -- like tablets replacing PCs

Often, technology trends seem challenging to decipher. But many times, they are easier to see than you might think. This is especially true with technology companies that sell consumer products and services that you know well and use personally.

An excellent example began in 2010 following the introduction of the iPad by Apple. It created the tablet computer industry that began taking market share from notebook computers. Progressively, personal computer sales growth slowed and then turned negative. This trend continues to accelerate today in 2013.

You likely have bought an iPad or other tablet computer in the last 3+ years since the iPad introduction and may well have now not upgraded your notebook PC for years.

The iPad is the delivery platform of choice for most consumer apps. And today it is the platform for many services developed for enterprises including companies' own internally created applications In fact, most developers are only focused on creating apps Apple and Android smartphones and tablets as their target devices. There is hardly any development of new software or apps products for PCs.

This transition to smartphones and tablets is called the "Post-PC era." And it appears unlikely to ever reverse back.

Once a major trend like the Post-PC era is identified, make sure most all of your investments are in companies that benefit from it. This means component, software and services companies that you buy should have a high proportion of their sales to leaders in the growth sectors like smartphones and tablets.

Or sell into the data center servers and networking sectors that benefit from the strong trend to "Cloud Computing."

To repeat our opening statements:

Investing in the best technology stocks can be very financially rewarding. Use these keys to successful investing in tech stocks and see if you enjoy the process and make money.

We are a new contributor to Seeking Alpha. These are the investing principles that form the basis of our investing philosophy that will be behind the investing ideas we will present from here forward.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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