Stocks and Shares

The safe way to invest in tech stocks (Part II of II)

Tech, and especially investing in tech, is permanently wrapped in a virtual cloud of hype and hope. Those that get it right, or get lucky, can get rich almost overnight. Those that get it wrong can wave goodbye to small fortunes, and even large ones. So how do you sort the wheat from the chaff? This week we’re investigating whether there’s a simple strategy you can use to profit from tech stocks (see here for part I).

Ten years ago, when it was still under eight years old and had only been listed for a year and a half, Google Inc. (now called Alphabet) published its financial results for 2005. Buried in the details it listed Yahoo! Inc. as one its main competitors (the other was Microsoft).

Jumping forward to today, Alphabet/Google’s revenues are over 15 times as big as Yahoo!’s. The company’s stock is worth almost 19 times as much as its erstwhile competitor.

Since Google stock was listed in August 2004 it’s up 1,152% (blue line in chart below). Yahoo (red, appropriately) is down 4%, and (more diversified) Microsoft (yellow) is up 82%.

Heroes and zeroes

StocksYahooGoogleandMicrosoft

How could you, as an investor, have known which horse to back a decade ago? The answer is that you probably couldn’t have, except perhaps if you were one of few industry insiders and tech experts. But many of them would have got it wrong as well.

Even the professional venture capitalists that specialise in backing technology companies will tend to choose more losers than winners.

Even the professional venture capitalists that specialise in backing technology companies will tend to choose more losers than winners. Their hope is that a handful of winners will go to the moon, even if most turn out to be today’s equivalent of the experimental flying machines of the 19th and early 20th centuries. (This kind of thing.) So where does that leave the most-likely-inexpert-in-the-field-of-tech private investor when it comes to this sector? Where does it leave you and I?

None of this is to say that technology startups aren’t a good idea. We need pioneers, investors and visionaries to come up with useful new things. And we need a lot of them to fail so that we find a few that work. It’s just that we shouldn’t necessarily want to risk our own money in this highly uncertain way.

One answer could be to look for established tech companies that don’t look too expensive. The problem with that is that they already could be on a low growth trajectory, in which case you’d be better off buying super-safe consumer staple stocks that sell food and drinks and the like.

Mature tech companies could even be on the way down, with new challengers nipping at their heels with better products. High tech has a habit of low staying power.

One such example could be Apple Inc. (NASDAQ:AAPL). It makes (mostly) good products, with a dash of style about them. And the stock looks cheap, at least on the face of it. The P/E ratio is just 9.9 times last year’s earnings, which is positively pedestrian in the world of tech.

But Apple has a few problems. About two thirds of its sales are mobile/cell phones. It enjoys a fat pre-tax net profit margin of 32%. And it last and heavily marketed brand new product launch – the Apple watch – can only be assumed to have been a bit of a flop. The company still refuses to separately disclose the sales figures for said appendage, nine months after launch. (Still, it’s doing better than Google Glass, a short lived face appendage.)

So is Apple the next Nokia or Blackberry, the previously fallen angels of the cell phone world? Could be. If Apple can’t find a new product to excite the fruiterati then it will quickly find itself in a world of price cutting. Profit margins will decline fast as it struggles to maintain market share. Volume growth may not be enough to keep profits propped up.

Apple’s main rival for smartphone sales is Samsung Electronics. which has a pre-tax net profit margin at Samsung Electronics is 14%, which is to say less than half of Apple’s profit margin. There (most likely) lies Apple’s future. Hence the stock isn’t necessarily cheap. The company may struggle to grow profits.

A smaller example of the risks is GoPro Inc. (NASDAQ:GPRO), a maker of video cameras that you can clip onto things, like yourself. For some reason everyone got very excited about this company when the stock listed in mid-2014.

GoPro rocketed by 140% in the first six months but is now down 72% since listing. The blockbuster film has turned out to be a flop. GoPro has GoneProne.

The world of tech investing is certainly a rough place. How do we sort our future Googles from our future GoPros?

The thing is that tech seems too big to ignore completely. After all the sector is about a fifth of the stock market by value. Surely there must be a simple way to get some exposure with a high chance of a decent profit?

Last week I was looking at whether gold has performed better than US stocks over the long run, as some claim. The clear answer was “no” (see here and here for more).

I focused on the S&P 500 index in the articles. But my analysis, which went back to 1971, also looked at the NASDAQ Composite, which is a tech-heavy index which happened to launch that year.

What I noticed is that the NASDAQ performed similarly to the S&P over 44 and a bit years. Before tax and including dividends, both stock indices returned about the same amount over time.

The S&P 500 had compound average capital gains (price rises) of 6.9% a year and an average dividend yield of 3.0%, taking the total to 10%. The NASDAQ Composite had compound average capital gains of 8.8% and a dividend yield of about 1.1%, which is 9.9% in total. Pretty close to each other.

After income tax on dividends, assuming they’re reinvested in the index, the NASDAQ actually comes out on top. In fact about 20% better after 30 years. Who wouldn’t want 20% more money in their retirement savings?

The point is that the NASDAQ Composite has been a highly profitable long term investment, despite being stuffed with higher risk tech stocks. But even more tech weighting can be found in the newer NASDAQ 100 index, which has been going since 1985. This index has 57% weighting to tech, 13.4% to healthcare (including biotech and diagnostic machines), and 1% in telecoms. It also contains no financial stocks (7% for the Composite index).

In reality the NASDAQ Composite and NASDAQ 100 have had similar performances. But since we’re looking for tech exposure, and the “100” has more tech weighting, that’s the one to go for.

The easiest way to invest is in the Powershares QQQ ETF (NASDAQ:QQQ), which tracks the NASDAQ 100 index. This a US$35 billion fund, which means it’s big, and it charges just 0.2% a year in fees, which is little.

But now for the million dollar question: is now the right time? QQQ’s P/E ratio was 20.4 at the end of December. Since then the price has fallen 14.5%, which puts it around 17.5 at the time of writing.

That may sound quite high, but it’s consistent with the higher growth rates of tech companies. It’s also way off the bubble high P/E of around 100 it had at the height of the dotcom bubble in late 1999 and early 2000.

Mind you there are still bubbly companies within the space, and the index. Amazon Inc. (NASDAQ:AMZN), with a market capitalisation of US$238 billion, rarely or barely makes a profit, even after 22 years of life. It has a P/E of 400. Ouch. But we’re interested in the average for the index.

Another thing to remember is that many, even most, tech companies need little capital. That means most of their profits can be reinvested in growth or (eventually) paid out to shareholders, either via dividends or share buybacks.

Put another way, the NASDAQ 100 companies have very high returns on equity (net assets): currently about 23% on average. That compares with 12% for the S&P 500, which is about typical for a broader country index.

By investing in QQQ you’re not buying either a moonshot or a flying machine that is doomed to crash. You’re buying a basket of already established (mainly) tech companies. Many of them are still growing quickly. Google still manages 15% a year, despite its huge size.

The price is reasonable and the growth will continue, as new things come along. And don’t forget that more than half the world’s population still don’t have internet access (see here for more). Online companies are playing in a still fast expanding playground.

This kind of investing is known as investing in “growth at a reasonable price” (or GARP). QQQ won’t make you mega rich overnight, but neither will it send you to the poor house.

Of course there will still be winners and losers within the index. You’ll get both, as well as the solid middle, just as NASDAQ investors have experience in the past. Overall you’re likely to do well, once they’re averaged out.

But a bit of caution is still required. Markets are very choppy at the moment, and many tech stocks in particular have been falling hard. It’s not the time to go charging into stocks of any kind. Fear has taken over from greed.

When the dust settles, and prices look reasonable, then a long term holding in the NASDAQ 100 is likely to be a safe and profitable way to invest in tech stocks. QQQ is something to put into your watchlist.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.