Some of the largest gains realized by individual investors in recent years have come from the technology sector. Large-cap tech stocks that are household names, such as the famous FANG stocks -- Facebook, Amazon, Netflix, and Alphabet (formerly Google) -- have easily trounced the market over the past three years. A group of lesser-known smaller-cap tech stocks may have done even better.
In the past year, Arista Networks, NVIDIA Corporation (NASDAQ:NVDA), Shopify, Square, and many more have all increased by more than 100%. I'm not just cherry-picking stocks -- over the trailing one-, three-, and five-year periods, the technology ETF (exchange-traded fund) QQQ Powershares Trust (NASDAQ: QQQ) has roughly doubled the returns of the S&P 500 index.
Thanks largely to the guidance of the Motley Fool newsletters, I've been fortunate enough to be invested in nearly all these stocks. But many investors are reluctant to invest in tech stocks because they don't understand the underlying technology. This makes sense: If investors don't understand what companies do, it is hard to judge the moats those companies have to protect them from competition and eventual commoditization.
Why even Warren Buffett avoids tech
Investors who avoid tech stocks are in good company. Warren Buffett -- his huge stake in Apple notwithstanding -- famously avoids investing in tech stocks. In late 1999, just months before the tech bubble burst, Buffett wrote an article in Fortune explaining why he had not invested in tech stocks during their huge run-up in 1999, a year that saw the NASDAQ Composite Index increase 86%. In his piece, Buffett explains two reasons for his approach:
- It's hard to assess the competitive advantage of a tech company.
- It's more difficult to identify winners in the tech space early on, before they make a huge move.
This makes sense. Innovation in this sector can come fast and from unexpected places. Before the arrival of Apple's iPhone, BlackBerry Ltd. looked like it would dominate the smartphone business for years to come. Before Facebook, MySpace looked secure as the world's dominant social network. The Eastman Kodak Company (NYSE: KODK) developed a digital camera as early as the 1970s, but dropped the project for decades because it interfered with Kodak's high-margin film business. The annals of investing are filled with once-dominant winners being taken to the woodshed by unexpected competition that out-innovated an industry's favored incumbents.
Yet the potential rewards of investing in the technology sector are too great for investors to ignore completely. Despite the difficulties inherent in technology, it's possible for investors to navigate through the space with market-beating returns -- and, no, you don't have to be a computer scientist or an industry expert to figure it out.
Here are two metrics I look for when evaluating a tech company's prospects that anyone can use -- no expertise required.
1. Fast-growing revenue
The first thing I look for when I get interested in a tech company is high revenue growth. I'm a sucker for a good story. So, when a company says it is developing a gizmo that is going to revolutionize virtual reality devices or make autonomous cars a reality, I often want to plunk down money for an investment on the spot. To save me from myself (and good storytellers), I need to see that the company is growing its revenue at a high rate. While I like to see accelerating growth, I can settle for stable growth if the rate is high enough. If a company is growing its revenue at a high rate (I generally consider that to be growth of 20% and above), that's proof that its products and services are in high demand.
Consider Nvidia. For years, I've been hearing that the company's graphic processing units (GPUs) are ideal for artificial-intelligence and autonomous-driving applications. I could spend hours studying the company's AI-based architecture for self-driving vehicles and still not be any closer to determining if it's a better bet than Intel's Mobileye platform, which, in contrast to Nvidia, incorporates lidar (light detection and ranging) technology in its attempt to penetrate the automotive market. Fortunately, I don't have to figure this out to know that Nvidia's GPUs are in high demand.
How do I know? Because when the company reported its 2018 fourth-quarter earnings, revenue grew to $2.9 billion, a 34% increase year over year. For the full year, revenue rose to $9.71 billion, an even greater increase of 41% year over year. Both numbers were records for the company. And almost all of that growth came from the company's gaming and data center businesses; its automotive revenue rose to a meager $132 million, a paltry 3% increase year over year.
This shows that Nvidia's autonomous driving technology is far from proven, which is also evidenced by the fact that there are virtually no autonomous-driving cars on the road today. If Nvidia's automotive division was a stand-alone company, I would never invest in it while it only showed single-digit revenue growth. As it is, Nvidia's high growth in its gaming and data center divisions allow me to take a flyer on the company's self-driving technology.
2. Stable or growing margin
A company I'm examining can't just be selling its products and services. Before I consider investing, a company must prove that it can make money doing so. After all, in 2001, Kodak was the No. 2 seller of digital cameras in the country. Investors who simply looked at its revenue growth rate in its digital camera division probably would have come away impressed. The problem wasn't that the company couldn't sell its digital products; it was that it was losing about $60 for each digital camera it sold.
Take another company I own and follow: Skyworks Solutions Inc. (NASDAQ:SWKS). Skyworks designs analog semiconductors that enable smartphones, Internet of Things devices, wearables, and smart-home devices to connect to wireless networks. A constant fear for semiconductor makers is that they will be commoditized by cheaper competition. I monitor this by keeping a close eye on the company's operating margin, which is its operating income divided by total revenue. This metric shows how profitable a company is.
My reasoning is this: If a company can grow or maintain its operating margin, that shows it still possesses pricing power. If a company has pricing power, it must still hold some sort of competitive advantage over competitors.
In its first quarter of 2018, Skyworks reported a non-GAAP operating margin of 39.4%, more than a half percentage point better than last year's first quarter. In fact, that quarter's operating margin is the highest the company has reported in the last two years. The lowest operating margin it has reported in that time is 36.5%. If the operating margin falls below that level in the quarters ahead, I'd begin to be concerned.
Looking at this metric, which the company makes readily available every quarter, doesn't require me to evaluate the company's TC-SAW (temperature-compensated surface acoustic wave) filters, compared to the more expensive BAW (bulk acoustic wave) filters from its competitors. Nor do I need to understand the technical design choices in evolving 5G standards (such as TDD vs. FDD) to know if the company's products are still in demand. As long as Skyworks can maintain its revenue growth rate and operating margin, I can be reasonably assured its products are still being purchased and are not being commoditized.
A non-techie's conclusion about tech
One of my favorite things about investing is that it forces me to learn about a wide range of topics. I recognize I am a tech neophyte, but that doesn't mean I don't try to learn about the technology used by the companies I invest in; it just means I don't rely on my limited knowledge to inform my investments. Instead, I look for clues in the company's earnings reports. If a company is showing accelerated revenue growth, I know that what it's selling is in demand. If a company shows a stable or improving operating margin, I know it still has pricing power.
So much of the innovation we've seen over the past three decades has come from technology companies, as the world has embraced everything mobile and digital. It would be a shame to miss out on the gains these innovations bring, simply because we don't understand the technical details. Fortunately, I don't think we need to be experts in these fields to invest.