Many growth investors like tech stocks because they occasionally generate market-crushing gains within just a few years. Over the past decade, e-commerce giant Amazon.com (AMZN -0.59%)rallied nearly 2,500%, while Baidu -- the biggest search engine in China -- surged nearly 2,000%.
Those gains look explosive, but many other tech stocks also bombed during those 10 years. Therefore, investors who are interested in this sector should remember five simple tips before buying their first tech stocks.
1. Understand what the company does
The tech sector is filled with companies that promote "hot" technologies. However, investors often buy shares of these companies on an analyst recommendation without really understanding what they sell. As Warren Buffett famously said, "Never invest in a business you cannot understand."
That's why Apple (AAPL 0.83%) is such a popular tech stock among both mainstream and institutional investors. Its business is easy to understand -- most of its revenue comes from its three hardware product lines (iPhone, iPad, Mac), but it's gradually pivoting toward paid services (Apple Pay, Apple Music, Apple Care) to reduce its dependence on hardware.
Other companies have hidden strengths. Amazon is generally known as an e-commerce site, but its most profitable business is actually AWS (Amazon Web Services), the largest cloud platform in the world. The profits from that business offset the much lower margins at its marketplace business.
2. Look for market leaders
When I invest in tech stocks, I generally look for "best-in-breed" market leaders. These leaders usually have strong pricing power, stable margins, and the ability to exploit economies of scale and bundling strategies to marginalize smaller rivals.
Amazon exhibits all these qualities in both the e-commerce and cloud markets. Cisco has the same strengths in the networking equipment market, while Salesforce has similar advantages in the cloud-based customer relationship management market.
3. Always look forward
The worst mistake a tech company can make is falling behind the tech curve. Yet larger tech companies often fall behind because they focus more on quarterly growth, dividends, or buybacks than boosting their research and development budgets. Market leaders, their egos boosted by temporary glory, also sometimes prematurely dismiss disruptive threats.
That's precisely what happened to BlackBerry (BB 0.26%), which controlled a fifth of the smartphone market seven years ago. After its market share plunged to nearly 0%, it decided to stop producing its own smartphones in late September. The same can be said about Intel, which surrendered the mobile chip market to Softbank's ARM Holdings' licensees, and Microsoft, which ceded the mobile OS market to Apple and Alphabet's Google.
If a tech company stops innovating and simply follows market trends, its high growth days might be over. That's what might be happening with Apple, which is pursuing "hot" markets like smartwatches and streaming music instead of launching new game-changing devices like the iPod and iPhone.
4. Understand the valuations
Investors often pay big premiums for high-growth tech stocks, but these stocks can be solid investments if their valuations are supported by comparable earnings growth. Amazon, for example, trades at 79 times forward earnings, but is expected to deliver earnings growth of 80% next year.
However, these valuations can be tricky if a company posts explosive sales growth with widening losses. In these cases, investors should check the company's cash position and free cash flow to better analyze the health of the business.
5. Don't ignore "old tech"
Many investors focus on the sexy high-growth tech stocks, but they should remember that slow growers like Cisco, Microsoft, Intel, and IBM are still great sources of stable income. These companies also buy back lots of stock, regularly raise their dividends, and trade at much lower multiples than higher-flying tech darlings -- making them ideal core holdings for your portfolio.
The key takeaway
The tech sector might seem overwhelming at first, but it all comes down to buying what you understand, identifying the market leaders and disruptors, and understanding their valuations. Investors who tick off these boxes while doing their due diligence might find some solid tech stocks to hold for the long run.