Investing in top technology stocks has been a simple and effective strategy to beat the market. Over the last 10 years, stocks in the Nasdaq 100 technology sector index delivered a total return of 459%, more than doubling the return of the S&P 500.
Secular trends, such as the digitization of the economy and the shift to cloud computing, should continue to fuel growth for top names in the tech sector. Three stocks that could continue to benefit from these trends are Okta (OKTA 6.86%), Taiwan Semiconductor Manufacturing (TSM -1.16%), and Adobe Systems (ADBE 2.17%).
Here's why these three top tech stocks should deliver great returns over the long term.
1. Okta: Boosting security for remote work
As more companies adopt cloud solutions, the market for cloud security is booming. Employees are getting more work done remotely, and that raises the risk of hacking and stolen login credentials. That's where cloud identity management comes into play. Microsoft's Azure Active Directory (AD) is a leader in this market, but Okta has carved itself a profitable niche that is driving phenomenal returns for investors.
While Azure AD is tied to Microsoft's ecosystem, Okta offers a solution that is completely independent of any platform. This distinction is one reason why Okta has delivered consistently high revenue growth of around 40% annually, fueling a 476% rise in its share price over the last three years.
Most importantly, Okta's dollar-based net retention rate continues to hover around 120% on a trailing 12-month basis. A retention rate above 100% shows that companies are continuing to adopt other services that Okta offers, which spells a lucrative future for the platform.
On that note, it's encouraging that Okta is already building a healthy stream of free cash flow -- the lifeblood of any business -- even as it invests to drive demand for its technology. Over the last year, free cash flow as a percentage of total revenue has improved from 6% to 13%, and should continue to increase over time.
The stock recently sold off following the release of the company's latest earnings report, where management issued guidance calling for revenue to slow to a rate of 29%-30% in fiscal 2022 (which ends in January). Still, Okta sees a massive addressable market to expand into. If anything, the recent dip in the stock price could be a great buying opportunity, as global spending on cloud IT services continues to grow every year.
2. Taiwan Semiconductor: Paving the way for faster computing
Taiwan Semiconductor Manufacturing (TSMC) doesn't make the headlines like the NVIDIAs of the world, but it is one of the most profitable and dominant companies in the tech sector. You probably own a smartphone or computer that uses TSMC's technology. It manufactures chips using the latest technologies for hundreds of companies, and it earns fantastic margins doing so. Over the last four quarters, it generated $45 billion in revenue, $10 billion in free cash flow, and an extremely high operating margin of 42%.
Its largest revenue source is supplying chips to smartphone manufacturers, which accounted for 48% of its revenue in 2020. It also makes chips for game consoles, computers, automotive applications, internet of things devices, and consumer electronics. Altogether, it held a 52% share of the global foundry market in 2019 and continued to report strong operating results last year, even as competition intensified across different markets. Demand for 5G smartphones and high-performance computing (HPC) applications drove a 25% increase in revenue in 2020.
Looking ahead, TSMC is already stepping up its capital investment roadmap to prepare for rising demand for 5nm chip technology and the 5G upgrade cycle. Management is planning to increase capital spending by roughly 50% in 2021, with most of the capital going toward process technologies, including 3nm, 5nm, and 7nm technology. Management expects this to drive more revenue growth over the next few years.
The stock looks expensive at a forward P/E of 30, but future demand for smaller and faster chips could justify that valuation. TSMC now expects revenue to grow at an annualized rate of 10%-15% through 2025, driven by megatrends in 5G and HPC applications.
3. Adobe: The shift to digital work is fueling growth
So far, we've looked at two stocks that are riding the trends in cloud security and high-performance computing. With Adobe, it's about the ongoing shift to digital workflows for consumers and businesses. Adobe is famous for its widely-used PDF file format, but it's also seeing growing demand for creative products used for photography, illustration, and video content.
Competition for productivity applications is intense. For example, Apple offers its own photo editing software for free, which offers some of the same features of Adobe Lightroom, but Adobe continues to innovate with new features that keep it a step ahead. During the pandemic, Adobe delivered record revenue performance, a testament to the strength of its offering in a competitive marketplace.
Adobe makes several applications for working professionals, but its flagship service is the Creative Cloud platform, a subscription service that includes access to Photoshop, Illustrator, Lightroom, and other apps. Revenue from this business increased by 31% year over year in the most recent quarter. This level of growth is somewhat inflated due to the high demand stemming from the work-from-home environment last year. But Adobe has been a growth machine over its history, and it's still going strong, with revenue and free cash flow more than doubling over the last five years.
Adobe has been one of the most rewarding tech stocks to own over the last decade, with shares returning 1,300%, but rising demand for digital applications should fuel the stock higher over time. More people are shifting to working on mobile devices, which management believes presents a long-term opportunity for further expansion.