The tech sector continues to be a bright spot in the U.S. economy. FactSet expects technology companies in the S&P 500 to earn net income that's 9.3% higher in 2014 compared to just 1.9% growth last year, accounting for between 15% and 16% of total revenues, making it one of the most profitable industries in the United States.
Venture capitalists and other early stage investors have been well aware of this potential. After IPO's like Rocket Fuel Inc. (NASDAQ: FUEL) and Twitter Inc. (NYSE: TWTR) last year, venture capital investments have only intensified as investors look forward to potential upcoming IPO's like that of Dropbox - a cloud storage company.
In this article, we'll take a look at how some parts of the tech sector may be overvalued as well as some investments that could help diversify a tech portfolio and may improve overall returns.
Lofty Valuations in Tech
Goldman Sachs strategist David Kostin sent a shockwave through the market in mid-January after saying that the S&P 500's valuation was lofty by almost any measure. For instance, he calculated a cyclically adjusted P/E ratio suggesting the index may be 30% overvalued in terms of operating EPS and 45% overvalued by reported EPS.
If the overall market seems lofty, then the tech industry may be especially vulnerable, particularly in private markets. For example, Dropbox is seeking to raise $250 million at an $8 billion valuation despite slowing growth while Snapchat famously rejected a $3 billion buyout offer from Facebook - two moves that could be indicative of a bubble.
In the public markets, Rapid Ratings found that Twitter closely matched the bubble IPO's of the 1997-2000 period, fitting 36 out of the 39 ratios that it associated with the bubble era. While companies like Twitter have grown user bases and revenues, investors have yet to see how that translates to profit, making them difficult to value.
Finding Industry Bargains
Many companies operating in the private and public portions of the tech industry may appear overvalued, but there are some companies trading under-the-radar that could be a bargain. Investors may want to take a closer look at these companies in order to balance out the risk in their portfolios by betting on value in addition to just growth.
With a price-book ratio of 0.3x, according to Morningstar, CrowdGather Inc. (OTCQB: CRWG), trades at less than the recorded value of its assets, creating a price floor of sorts. Its price-sales ratio of 2.4x is also significantly lower than the industry's 7.5x average.
Since the middle of last year, the company has been undergoing a restructuring that involved cutting its losses, raising $1 million in financing, and planning to launch its new ad platform designed to revolutionize forum advertising. The company has not yet reached profitability and continues to consider strategic alternatives. However, insiders appear confident in the strategy with CEO Sanjay Sabnani and Director James Sacks both buying shares this year.
Building Balanced Portfolios
Investors interested in the tech sector may want to balance their portfolios between both growth and value stocks, as well as small-cap and large-cap stocks, in order to optimize their returns. High growth companies like Twitter or Rocket Fuel may seem attractive now, but they could turn out to be quite risky, especially if they can't turn revenues into profits.
Blue chip stocks like Microsoft Inc. (NASDAQ: MSFT) or Google Inc. (NASDAQ: GOOG) can help lower the beta coefficients of a tech portfolio while smaller undervalued, asset rich companies like CrowdGather could reduce risk while providing upside.
Investors may want to consider mixing these types of investments in order to help improve overall risk-adjusted returns over the long-term. In particular, CrowdGather may offer an opportunity to diversify a tech portfolio with its low price-book ratio, insider buying, and promising future prospects that make it worth a second look.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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