Technology Stock Investing - Keys To Success

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Includes: AAPL, ALBBY, AMAT, AMZN, ANET, FB, NFLX, NVDA, PFPT, STMP
by: Silicon Valley Insights

Summary

Product cycles and new technology trends trump most business and economic cycles.

Innovation versus competition continue to be important to fundamentals.

Continue to judge management teams as business people, look for large markets, be a momentum investor and generally buy highly profitable cash generators.

Retaining winners and quickly selling losers is very important.

Major trends are not hard to see, especially for consumer products and services.

Investing in the best technology stocks continues to be very financially rewarding. For example, YTD the first 9 months of 2017, our nine Focus Strong Buy rated stocks are up an average of 52.5%. The details of this:

  • 32.3% Apple
  • 56.9% Applied Materials
  • 27.5% Amazon
  • 93.8% Arista Networks
  • 44.4% Facebook
  • 46.0% Netflix
  • 64.6% Nvidia
  • 25.1% Proofpoint
  • 81.9% Stamps.com

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 and new technology trends trump most business cycles

New products, markets and services are the most important keys for technology company success, especially over any sustained period of time. Short-term, changes in the macroeconomic environment can have some impact and need to be watched for their both their actual impact on business levels and on stock valuations.

Short-term, brokerage firm analyst opinion and target prices can impact stock prices so be ready to take advantage of stock price corrections that are triggered by value-oriented analyst lowering their ratings just due to valuation increases of great companies.

The upcoming Q3 earnings reports will also reduce uncertainties, and thereby, could allow some re-expansion of multiples to revenues and earnings. This is especially important for the highest growth companies that carry the well-deserved higher valuations. Also, over the next several months next year's earnings become this year's earnings and that benefits the valuation of high-growth, higher valuation shares. Especially those of smaller capitalization companies.

2. Innovation versus competition continues to be an important fundamental concern

In the technology world, innovation is highly important. Look to invest in companies that are leaders in new emerging markets that have the potential to become far larger and massive in absolute terms. Currently, major trends include:

  • Cloud computing
  • TV and mobile device displays moving from LCD to OLED
  • Artificial Intelligence enhancing many things
  • Smart homes
  • Smart wearables
  • Autonomously driven electric cars and trucks, including on-demand

3. Judge company managements as business people.

Innovative new technology companies are often founded by people with technical skills and creative genius. However, some of them are young and inexperienced in running businesses. Look for the venture capitalists backing companies or others to encourage adding high-quality managers with excellent business experience.

There are not too many Steve Jobs, Elon Musk or Jeff Bezos quality founding visionaries who drive their companies successfully without help for many years. And even Steve Jobs needed some seasoning before he really was hyper-successful. Companies like Google and Facebook are excellent examples of where adding very high-quality business people at the right time made a huge difference.

Before investing in technology company shares, we highly recommend joining the quarterly earnings calls (or replays of them) with managements. Do several of them in chronological order and take notes. You will see if the current and future business is improving or slowing or just hit a temporary speed bump. Avoid companies who frequently miss their guidance.

Especially if you like the products of the companies in which you are considering an investment, investing this way can be enjoyable as well as rewarding.

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 very large markets. Think in terms of companies addressing markets measured in billions or many billions of dollars.

Ideally, the companies' offerings should be something most all consumers or and/or businesses would like to have. We often call this selling something every man, woman, child wants to have. Think of Apple devices, Amazon online shopping and home deliveries, Tesla cars, Facebook pages and Netflix entertainment.

In enterprise IT the company's offerings should be something that most all organizations would find valuable in generating incremental revenues, dealing more effectively with customers, suppliers and partners and/or in reducing costs.

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 progressively more exciting. This is a corollary to investing around 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 continue rapidly growing 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 high-quality 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 our Keys to Success 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 of their 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 30% per year. And more desirably 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 40% and preferably 50%+.

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.

We call this being in the "Investment Mode". Amazon is a rare company in that it has grown so rapidly over 20 years that investors have accepted the lack of substantial earnings because its rate of expanding into new areas is so impressive.

Limit ownership of stocks of companies being in the investment mode to only 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" when earnings are growing faster than revenues, its shares will likely 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 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 in the technology sector.

6. Retain winners, quickly sell losers

We suggest selling losers faster and selling winners only gradually.

The greatest challenge in selling positions in great fast-growing companies just because the overall equity markets are declining is to rebuild positions at lower prices before they rebound above where you sold them. And you may have triggered taxes.

When the declines in individual company shares are a result of a broad market decline, they can rebound strongly and rapidly as soon as the market does.

It is human nature to want to get back to even before you sell a stock that goes down after you purchase it. But 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 one day of a fairly sharp correction if it's just because one analyst lowered his or her recommendation because of price and valuation. When that occurs, often the stock will be weak only that one day and rebound the next day or as soon as there is the next piece of good news or overall stock market strength.

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 too heavy an over-weighting.

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. But experience shows it often will reduce your overall portfolio performance because the best companies continue to perform the best. So again, we suggest selling winners only gradually.

7. Invest in highly profitable cash generators

A key element to successfully using the investing style we recommend here is to focus on owning high quality, highly profitable strong cash generators. This especially applies to seasoned, not newer companies.

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 or that competition is increasing.

8. Many major trends are not hard to see

Technology trends can 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.

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.Thank you for reading our research. We hope you like that we focus objectively on the most important investment variables, the latest news and our judgment, including Focus Strong Buy, Strong Buy, Buy and Neutral ratings. Please follow us if you would like to see our research and recommendations on the wide-ranging breadth of high-quality, high-growth technology and other stocks. With your support, we will be able to launch a Marketplace service, including a chat room where we can respond to your questions.

Disclosure: We have positions in Apple, Applied Materials, Alibaba, Amazon, Arista Networks, Facebook, Netflix, Nvidia, Proofpoint and Stamps.com. 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.

Disclosure: I am/we are long AAPL, AMAT, ANET, FB, NFLX, BABA, NVDA, PFPT, STMP.

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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