ETF Investing Guide: The Problem With Tech Stocks

by: David Jackson

Technology is a unique area of investing for one simple reason: tech companies seem to have the ability to grow faster than, and to reach market shares greater than, almost any other type of company. New technologies that provide compelling functionality and return on investment spread rapidly. As a tech company’s product becomes the de facto standard (interoperability is often critical in technology), it can dominate its market. Economies of scale - partly due to the networking effects of standardization - are particularly intense in technology.

So the companies that win (think Intel and Microsoft) win really big. And it follows that the tech companies that don’t win either fail completely or are at best lackluster.

This observation is born out by profit data from tech stock investing. The seminal work on this is The Technology IPO Yearbook, compiled annually by Morgan Stanley analyst Mary Meeker. In it, she shows that of the 1,705 tech companies that went public over the last 22 years, (as of end 2001) 5% of them accounted for 100% of the wealth creation.

This presents interesting problems for investors. First, you can make significant profits in technology stocks, but stock picking is hard. If 5% of the stocks made 100% of the profits over the last 22 years, then broadly speaking you would have lost money with the other 95% of them.

Second, to make those outsized profits from the handful of winners, you need the resolve to hold on to them for long periods of time, even when the market is falling or the company’s business doesn’t look good. How many of us have the guts to do that? How many people are not tempted to “take profits” on a stock that is up over 100% when doubts emerge about the company’s competitive position or short-term profitability?

Third, if you stay the course and hold on to the stocks that will turn out to be winners, they will dominate your portfolio. If you’d invested in tech stocks over the last 22 years, holding on to your winners, you’d have ended up with an account massively dominated by Microsoft, Dell, Oracle and Cisco. Goodbye diversification.

Well, let’s assume that you, as an individual investor, decide to go for tech investing, and you’re prepared to stomach the enormous portfolio concentration that true success requires. Here’s the next problem: When do you sell? You see, even though your portfolio would be filled with “dominant” tech companies, they would still be susceptible to unforeseen and disruptive competition. And if you don’t sell them in time, you’ll lose a lot of your compounded profits. Remember US Robotics, which dominated the modem market? Its business is now commoditized. Or what about Sun Microsystems? Only a couple of years ago, Sun was the undisputed leader in the market for computer servers. As the company said, it was “the dot in dot-com”. But now the combination of Linux with Intel microprocessor-based hardware has thrown Sun’s market position and future into uncertainty. And we’re not talking about a small company here: Sun still has a market capitalization of about $10 billion, though much of that reflects the company’s cash, not incremental value placed on its business by investors.

My gut feeling is that it is precisely these difficulties that repel Warren Buffett from this sector. Buffett is the king of long-term investing, and understands the power of after-tax compounding better than almost anyone else. And Buffett never buys technology stocks or technology companies.

The moral? You can make money trading tech stocks. But you’re playing against a lot of smart hedge funds, you’ll likely realize short-term capital gains, and you’ll incur significant trading costs.

In contrast, if you’re looking to invest in technology for the long haul, you’ll need nerves of steel, acceptance of a highly concentrated portfolio, and a real appetite for company risk and volatility. If you’d prefer less risk, less volatility and greater diversification, you’ll need to look elsewhere.

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