The risk associated with the stock market frightens many potential and existing investors. Still, a well-built portfolio of stocks properly selected over a period generally outperforms alternative investments. In this article we are going to discuss different measures to keep in mind while building a portfolio of technology stocks.
Companies engaged in the production/delivery of technological goods and services like computers & peripherals, IT services, semiconductors, telecom, software, etc. comes under the technology sector. This sector is highly suited for growth-oriented investment as technology companies generally re-invest profits for future growth instead of giving higher dividends. With the increasing importance of technology, these stocks have become leaders in equity markets and the general economy.
There are a variety of factors that are especially relevant to selecting technology stocks. So, while selecting stocks for your tech portfolio, we will have to keep these factors in mind in addition to standard measures of stock analysis. Understanding the market in which you are investing and knowing your targets will help build a strong portfolio. Here are some measures you can consider while building your tech stock portfolio:
Criteria Particular to Technology Stocks
Measure the pulse of the economy for timing the market: The performance of the tech sector is highly correlated with economic activity. Search for undervalued tech stocks during scenarios like the recent economic recession. Here prices are low as fresh investments in technologies during such period decline drastically. Similarly, gradually book profit on technology stocks during heated market conditions when stock prices are high on the wake of increased investments in technology during growth years.
Gauge the leverage factor: Technology sector stocks generally have modest amounts of debt and strong balance sheets, but it is not always true. While analyzing tech stocks with hefty debts make sure the company's cash flows are sufficient to cover debt payments. To gauge leverage of the company use leverage ratios like debt/equity. Debt equity ratio is debt divided by shareholders equity. This ratio indicates the capacity of a company to repay its debt if liquidation of the company occurs. High debt equity ratio shows the risk to equity holders. Thus, highly leveraged companies should be avoided and investor should look for tech stocks with a low debt equity ratio like Towerstream Corporation (NASDAQ:TWER). The company is a 4G service provider in the United States. Towerstream Corporation is financially sound and its debt/equity ratio is low at 0.04.
Life line of tech stocks - Research and Developments: Investment in research and development is very crucial for the future growth of a tech company. If investment in R&D is declining continuously, the growth prospects for such companies would be limited. Though, majority of these companies reduce expenses on R&D during recessionary environment. However persistent decline in such expenses by any company for a long period hurts its future growth, as new technologies by peers would render its technology obsolete. Tech majors like Google Inc. (NASDAQ:GOOG), Apple Inc. (NASDAQ:AAPL) etc. spend heavily in product innovation (R&D) for maintaining leadership in their respective markets. Apple's recent spat with Samsung goes to show how important it is for a tech company to stay on the cutting edge of technology and not borrow technology from other companies without proper licensing.
Seasonality: Interestingly, the technology sector also exhibits some seasonality in its revenue flow which should be kept in mind while comparing periodic results. For example, budgeting cycles of clients (large firms) affects revenue flow of a software company as project flow surges at the beginning of the year once the client's budgets are defined. So, it is important for tech stocks to always compare y-o-y revenue and earnings instead of comparing over the quarter.
Other Common Criteria (also suitable for selection of tech stocks):
Apart from specific criteria that we discussed above, some common stock selection measures like financial ratio analysis, diversification and volatility are also important criteria's for technology stock selection.
Detailed analysis of financial statements particularly of financial ratios helps in deciding about investment in a particular stock.
The investor must look at the PE ratio (Price Earnings ratio). PE ratio is equal to current market price of the stock divided by its EPS (Earnings per share). The higher the PE ratio of a company as compared to its peers the more overvalued is it considered. For example, in computer peripherals segment you should avoid investing in stock like Universal Display Corporation (NASDAQ:PANL) as it has a very high PE ratio of 66.69. However, investors can consider investing in stocks like Mercury Computer Systems (NASDAQ:MRCY) and SMART Technology (NYSE:SMT) having relatively low PE ratio of 13.11 and 18.25 respectively. The changes in PE of a company over a decade against that of its peers also provide a broader picture of the strength of the stock.
ROE (Return on Equity) is used by investors to decide whether a company is a viable investment opportunity. ROE is found by dividing the total earnings after taxes by shareholders equity. Higher the ROE of a company the better it is as the business would be able to generate cash internally and thus would reduce requirement of obtaining debt. Therefore investors should aim to buy shares having high return on equity.
Enterprise/ EBITDA multiples: This measure is derived by dividing enterprise value of a company i.e. sum of its market cap and total debt by its EBITDA. This ratio measures market value of a company against its earnings. Technology stocks having low enterprise/EBITDA ratio should be considered for investment.
Book value of stocks is another measure to gauge whether a company is worth investing. The book value of a company shows the worth of a company and is equal to the excess of total assets over total liabilities appearing in the balance sheet. If the market price of a company's share is below its book value then the company is undervalued and one must look forward to accumulate such a stock.
Diversify your investment within the sector: Despite investing in a single sector, one should try to diversify technology portfolio by selecting stocks from different groups within the sector like IT, Computers & peripherals, Telecom etc. to minimize investment risk.
Volatility is the name of the game: High volatility stocks give chance to achieve high returns though they pose higher risk also. Historical volatility observed in stock prices suggests possible future movement potential of a stock. Beta is a measure which compares the volatility of an individual stock as compared to bench mark market index. A beta of more than 1.0 means that scrip fluctuates more than market index, whereas a lower beta means it fluctuates less than the market. For example, Perficient Inc. (NASDAQ:PRFT), an information technology consultancy, with beta of 1.81 is expected to move faster than the market index.
Based on these factors investors should select stocks for their portfolio. The time horizon for investment and investors' expected return for the portfolio should also be kept in mind while investing funds and harvesting returns.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.